Highlights:
· Investors seem resigned to the fact that interest rates will remain higher for longer, largely due to a resilient labor market.
· The Federal Reserve is in a tricky spot because inflation is lower than expected, but the economy is stronger. The Fed announced at their September meeting that they might hike rates one more time later this year.
· China, the poster child for global growth as of just a few years ago, now faces significant economic headwinds.
· Confusion should be the default state for anyone trying to predict the direction of the economy or equity markets.
Commentary:
“Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time – especially in times of chaos and havoc – will always win.”
-Morgan Housel, Author, The Psychology of Money
We have discussed interest rates ad nauseam in our last few commentaries, but rightfully so given the impact of rising rates on stocks and bonds alike. We are now at a point in the rate rising cycle where the consensus seems to be that rates will need to remain higher for longer because interest rate hikes have not yet been fully felt by the economy. The Fed affirmed this view at its September meeting, in fact indicating that there might be one more rate hike later this year. In particular, the labor market has proven remarkably resilient despite a series of interest rate hikes intended to slow the economy.
The Federal Reserve is seeking to cool hiring with the hope that, if companies are less eager to add workers, fewer workers will quit to seek higher-paying positions elsewhere, and businesses will then be under less pressure to raise pay to attract and retain workers. The Fed hopes that less wage pressure will help lower inflation because businesses will no longer be in a position where they need to increase prices to offset higher labor costs. A jump in the unemployment rate during the quarter from 3.5% to 3.8%, and reports showing that wage growth and the so-called quits rate, which measures voluntary resignations, are trending lower, offer a glimpse of hope that the tight U.S. labor market might finally be easing. On the other side, job openings in the U.S. surged higher in August and September driven by faster hiring in white-collar industries. Strong jobs growth continues to fuel consumer spending and sustained overall economic growth.
While personal income growth slowed during the quarter, consumer spending remained robust. In the three months ending in September, U.S. retail sales rose an annualized 6.4%, the largest end-of-quarter advance since June 2022. In addition to the strong labor market, many consumers locked in ultralow rates on mortgage and auto loans in the decade-plus that followed the 2008 financial crisis. While consumer spending continues to bolster the resilient U.S. economy, it has also resulted in a decline to the personal savings rate and leaves household balance sheets more fragile. This is a perfect example of the fine line that the Fed is walking – slowing down income growth should help moderate inflation, but if it slows down too much a consumer-spending pullback might ensue that drives the economy into a recession.
A 30% surge in oil prices since June, driven by cutbacks in supply by Saudi Arabia and Russia, has gas prices at their highest levels in almost a year and further complicates the Fed’s challenge of trying to pilot the economy into a rarely seen soft landing. Surging energy costs played a role in tipping the U.S. into recession in the mid-1970s, early 1980s, and early 1990s by driving up inflation and robbing consumers of purchasing power.
There is an equally big story that is coming out of China that could have repercussions across the globe. Just a few years ago, China’s economic growth inspired worldwide envy. Today, however, China’s real estate market is in a serious slump, consumer spending is weak, and unemployment among young adults has surged above 20 percent. China’s government responded to this torrent of dismal news by cutting interest rates and withholding economic data. This time around, however, economists and investors are not convinced that lower borrowing costs and transparency are what China needs to rekindle growth and restore confidence in its economy. They also are not convinced that China’s long-favored emphasis on production and investment in factories, skyscrapers, and roads is the answer because the consequence of these policies has been overcapacity and an increased propensity for deflation. China’s leaders have been reluctant, to this point anyways, to give direct government support to consumers, in part because of President Xi Jinping’s ideological bias against welfarism.
In fact, China’s deepening economic malaise resulted in temporary falling consumer prices in July. This is the opposite of what happened in most of the rest of the world, with many countries still trying to tame inflation that surged when Covid-19 restrictions eased. The danger of a deflationary cycle is that if the expectation of falling prices becomes entrenched it could further undermine consumer demand, exacerbate debt burdens, and make future stimulus measures ineffective. Deflation is particularly risky for countries with high debt burdens like China because it will add to debt servicing costs for borrowers and could prompt them to spend and invest less. Fortunately, Chinese consumers spent more freely in August to help return inflation above zero. In addition, August reports showed higher-than-expected new lending by banks and a third straight monthly improvement in manufacturing. This helped China’s economy grow at a faster-than-expected clip of 1.3% in the third quarter.
To make matters worse, China’s exports to the rest of the world tumbled during the quarter, despite a rise in exports to Russia. Cheaper Chinese exports may help ease inflationary pressures in developed countries, but also could hurt foreign competitors and lead to job losses.
The bigger story might be China’s fraying trade ties with Western developed countries. U.S. President Joe Biden issued an executive order during the quarter that, starting next year, would prohibit private equity, venture capital and joint venture companies from investing in some Chinese companies developing advanced semiconductors and quantum computers. The Biden Administration’s goal is to prevent China from producing cutting-edge technology for its military. The executive order will also require Americans doing business in China to inform the U.S. government about direct investments in artificial intelligence. The Biden administration has also kept in place many of the tariffs on goods from China and other countries implemented by the Trump administration.
On the surface, China’s demographics, real estate market, and financial risks are all too similar to Japan in the 1990s, where economic growth stagnated for three decades after its equity and real estate bubbles burst. One key difference between China and Japan, however, is that China has a very strong central government that will likely do whatever it takes to avoid a deflationary cycle. Furthermore, China has a huge domestic market and many countries still see untapped opportunities in consumption and services. Thus, despite foreign direct investment plunging to a 26-year low earlier this year, many companies from Europe and some emerging market countries are still investing in China. Accordingly, we believe the comparisons to Japan are extreme and a more likely outcome is that China simply transitions to a slower growth economy.
China is hoping to avoid becoming the most recent country, following the Soviet Union in the 1960s and Japan in the 1980s, to stagnate after achieving rapid growth for several decades. We came across a quote by David Leonhardt of The New York Times, from a story he wrote for The Times Magazine thirteen years ago, that we believe is still relevant today and captures the current challenges facing China:
To continue growing rapidly, China needs to make the next transition, from sweatshop economy to innovation economy. This transition is the one that has often proved difficult elsewhere. Once a country has turned itself into an export factory, it cannot keep growing by repeating the exercise. It can’t move a worker from an inefficient farm to a modern factory more than once. It cannot even retain its industrial might forever. As a country industrializes, workers will demand their share of the bounty, as has started happening in China, and some factories will start moving to poorer countries. Eventually, a rising economy needs to take two crucial steps: manufacture goods that aren’t just cheaper than the competition, but better; and create a thriving domestic market, so that its own consumers can pick up the slack when exports inevitably slow. These steps go hand in hand. Big consumer markets become laboratories where companies know that innovations will be tested and the successful ones richly rewarded.
In the current political climate, it’s fair to wonder if these actions are indicative of deeper changes that are under way, in which the West and China do more business with their political friends and less with each other. This would unwind decades of deepening global economic integration. The U.S. and Europe have already started trading more with each other, Mexico has supplanted China as the U.S.’s largest trade partner, developing countries have started shifting their exports to China rather than the West, and trade between China and Russia has risen dramatically over the past year, and is expected to reach $200 billion by the end of the year.
In a breath of fresh air, Japan reported during the quarter that its economy is growing at a 6% pace thanks to the country’s weak currency boosting exports and an uptick in tourism. After decades of stagnation, Japan is now outpacing growth in both the U.S. and China. This was the third straight quarter of growth for the Japanese economy, which finally surpassed its prepandemic size in real terms. Ironically, weakness in Japan’s trading partners, including the U.S. and China, means the rise in exports may not be sustainable in the near term. For this reason, many economists believe the government should not stop spending and the Bank of Japan should not tighten monetary policy until the U.S. and China return to their next economic recovery cycle.
Elsewhere, the European Central Bank hiked its key rate for the 10th time in a row during the quarter to an all-time high, citing that inflation was “expected to remain too high for too long.” However, the bank also signaled that its latest hike might be the last for the time being because “the governing council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.”
The Bank of England was one step ahead of the ECB, ending its run, for now, of 14 straight interest rate hikes at its September meeting. The streak of rate increases began in December 2021 and brought its main policy rate to a 15-year high of 5.25% in August. Cooler-than-expected inflation was the impetus behind the rate pause. However, Bank of England Governor Andrew Bailey issued a statement that was very similar to the comments made by Fed Chair Jerome Powell – “Our previous increases are working, but let me be clear that inflation is still not where it needs to be, and there is absolutely no room for complacency. We’ll be watching closely to see if further increases are needed, and we will need to keep interest rates high enough for long enough to ensure that we get the job done.”
To conclude, equity investors seem resigned to the possibility that interest rates may be higher for longer as central banks shift gears to a more data dependent approach with a goal of achieving a healthy labor market for the long term, in addition to price stability. On the positive side, inflation is down, major central banks such as the Fed and ECB are signaling a possible pause after a historic series of interest rate increases over the past 18 months aimed at tackling a surge in inflation unseen since the 1970s, the U.S. is still adding jobs, but at a more reasonable pace, and wages are currently rising faster than prices, but not fast enough to renew worries about higher inflation. The recent spate of positive economic news should not be overstated, because the Fed still has a very difficult balancing act ahead of them to meet their dual mandate of stabilizing prices while keeping unemployment low. Signaling a peak in interest rates now, risks letting excessive inflation become entrenched. In fact, some central banks, including those of Australia and Canada, halted rates in recent months, only to start raising again.
Even given all of the information above, as always, we would remind you that confusion should be the default state for anyone trying to predict the direction of the economy or equity markets. It is critical that investors always remember that the stock market is too unpredictable in the near term to take either a bullish or a bearish stance. To quote Howard Marks of Oakmark Capital Management:
“Confident” is the key word for describing a member of the “I know” school. For the “I don’t know” school, on the other hand, the word – especially when dealing with the macro-future – is “guarded.” Its adherents generally believe you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of investing in the absence of that knowledge.
2022 reminded us that bull markets do not last forever, but it is also important to remember that every bear market in history to this point has been temporary. Those of you that remember the story of Chicken Little might recall that Chicken Little treated a single acorn falling on her head as a sign that the sky was falling. It is all too easy for investors to mimic Chicken Little and treat every negative headline as a surefire sign that the economy and/or equity markets are bound to crash. Prudent investors shun the Chicken Little mentality and instead focus on setting up and maintaining a financial plan, managing their emotions by ensuring they always have sufficient cash and fixed income in their portfolio to meet their anticipated withdrawal requirements for several years, and avoiding reacting to the endless daily noise that the media generates.
Urban Financial Advisory Corporation – October 2023
Disclaimer:
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