Update on the Economy and Investment Markets 6-3-23

Welcome to the Stearns Financial Poolside Chat.

Breaking News: As we go to press, it appears to be a done deal (pending President Biden’s signature) – Senate passes U.S. debt ceiling bill, averting a U.S. default.

While many economists have been backing off their U.S. recession forecasts, we still see rolling recessions happening under the surface of the broad economy. A number of our clients who own their own businesses or work in corporate America are experiencing these downdrafts, while many others are seeing no turbulence in their particular markets. Shifting consumer demands have been traced as the primary culprit in these rolling recessions.

One of the brightest spots of the last U.S. jobs report was prime-age labor force participation, which rose to its highest level since March 2008. That underscores continued success in getting workers back into the workforce, which is exactly what the Fed has been looking for to ease the labor shortage that has led to rising wage inflation. However, more workers haven’t yet led to easing wage growth, which is one more fact that suggests to us that the Fed will keep interest rates higher for longer. Note: The May jobs report released Friday June 2^nd continues to demonstrate a strong labor market, with U.S. employers adding 339,000 jobs versus the 180,000-190,000 projected by economists. While labor force participation remained unchanged, the unemployment rate did rise to 3.7% from 3.4%. A key inflation indicator, average hourly earnings rose 0.3% for the month, in line with expectations. The health of the labor market will continue to be closely watched given its importance to consumer spending and the U.S. economy.

Strong wage growth is usually a good thing, a sign of a strengthening economy. With inflation still an issue (albeit lessening in recent readings), faster and stronger pay hikes make it more difficult for the Fed to maintain price stability. Strong wage growth also puts downward pressure on corporate profit margins – leading to less robust corporate earnings, the backbone of stock appreciation over time. This highlights the paradox we’ve discussed in many prior Chats that a strong economy (here or overseas) doesn’t always mean strong company earnings and a strong stock market. “Goldilocks” (not too hot, not too cold) is often the ideal environment for a strong stock market.

Some data recently released show continued resilience in the U.S. housing market:

• Building confidence. The National Association of Home Builders Index, which measures homebuilder sentiment, improved for the fifth month in a row, continuing its climb from a rate-hike cycle low of 39 in December to 50 in May – a level not seen since last summer.
• New home building. Housing starts ticked up 2.2% in April, reaching an annualized pace of 1.4 million, versus 1.37 million in March. Starts for apartments were particularly strong at 5.2%, surpassing the 1.6% increase for single-family homes.

Sturdiness in the new-home market, however, has come while existing-home sales are fluctuating between hot and cold. Buyers materialize when mortgage rates dip and disappear when mortgage rates rise. The National Association of Realtors reported a sharp decline in existing home sales and prices in April, which they blamed on a lack of inventory, as the current supply of existing homes is only about half of what’s considered healthy.

SFG’s Take: Many crosswinds continue to create turbulence in parts of the U.S. economy, while other parts remain steady or are growing. Many other countries and companies overseas have favorable valuations, higher dividends and strong balance sheets. In this environment, we are considering additional diversification options, including alternatives to bonds and stocks, to help provide better portfolio stability and inflation protection.

Key Points to Consider

Super Trend Update – Artificial Intelligence

In one of our Super Trend updates in 2019, we discussed how the eventual rise in artificial intelligence would create both happy and unhappy outcomes.

Google CEO Sundar Pichai has taken the happy outcome side to a history making level – he recently likened the Artificial Intelligence revolution to the harnessing of fire! That’s big and perhaps one of the biggest developments within the massive technology accelerator super trend. AI needs digital “kindling” for the fire to burn hot, meaning advanced microchips. A shortage of these chips has created a gold rush to build advanced chips, or find workarounds that involve a new type of digital architecture.

The main near-term benefit from the AI mania is many services you may already use are being upgraded to be a bit better. Better could mean easier for you to find what you’re looking for – just like so many features in your car just do things automatically, you may not realize that enhanced AI is the reason. Dozens of businesses we work with are finding ways to make themselves a little bit better either internally or with their customers. AI enhancements are being touted as the catalyst for the next great wave of productivity improvements in the workplace.

Just a reminder, however, that playing with fire, even digital fire, can burn you. Stories proliferate about situations where AI is also not ready for primetime just yet. The NY Times reported that lawyers suing the Colombian airline Avianca submitted a brief full of previous cases that were made up by ChatGPT. These are known in the AI world as hallucinations – apparently ChatGPT didn’t “understand” that it needed actual cases for this legal research.

After opposing counsel pointed out the nonexistent cases, U.S. District Judge Kevin Castel confirmed, “Six of the submitted cases appear to be bogus judicial decisions with bogus quotes and bogus internal citations,” and set up a hearing as he considers sanctions for the plaintiff’s lawyers.

Lawyer Steven A. Schwartz admitted in an affidavit that he had used OpenAI’s chatbot for his research. To verify the cases, he did the only reasonable thing: he asked the chatbot if it was lying. The AI chatbot insisted the cases were real. Buyer (or user), beware.

Frequently Asked Questions

Q:   My latest Financial Independence Roadmap® update indicates we’re okay, but not with as much safety cushion as I’d like. On the one hand, this suggests we keep higher cash balances to provide more safety. On the other, we could invest some of our cash and be making double or more the returns in other investments with you and help improve our safety margin longer term. How do we balance these competing priorities?

A:   Usually, we suggest a combination of strategies – for pre-retirees, enough cash to provide a cushion for major emergencies or a loss of income, usually six months of living expenses (net after tax), with enough invested to provide a reasonable margin of safety later in life. Everyone is different with how much they want to live for today versus live for a future day.

Business owners’ cash reserve needs are highly variable, depending on the type of business and what risks they are hedging, like business interruption.

For retirees, having the six months plus another 6-18 months of cash is usually an adequate safety margin over and above what their portfolio of investments can provide.

One key that hasn’t been the case for the last 15 years – today we are in a unique position where cash (if invested in a high-yield Savings account, Money Market, CD or Treasury Bill) is able to earn over 4%, and sometimes over 5%, which results in investors not giving up as much return by holding cash than what has been given up since 2007, when cash returns were minimal to non-existent. This has resulted in many clients holding more cash than normal, knowing they are earning a portion of the return modeled in their roadmap with very minimal risk.   

Keep in mind that social security often provides a good base towards fixed expenses. Some of our clients also have a pension, which helps make their safety margin higher and requires less surplus cash. Many of our clients have cash value life insurance that provides yet another safety layer of cash via withdrawals or loans if needed. Some clients view their built-up home equity as a cash source via a home equity loan (although those rates have soared in the last year, making this option less appealing, but still an option in a pinch).

A lot also depends on your living expenses. If 50% are fixed expenses (needs) and 50% are variable (wants), then you have more flexibility to reduce expenses if times get tough. Note that one person’s want may be another person’s need – when safety margins are tighter, good to know what each person in a couple is willing to do in future scenarios.

SFG’s Take: Every situation is different. We can help you weigh all the factors and provide options for the best “cash versus investing” balancing.

Summary

Many factors still indicate a slower growth scenario for the U.S. and global economy. We see more rolling recessions already occurring in the U.S. A resolution to the debt ceiling issue would help cushion some of the current rolling recessions and lower overall U.S. recession risk later this year.

Wildcard risks (low probability, high possible impact) discussed in this and previous Chats remain and suggest some caution. Included among these risks are Putin’s future actions. SFG is balancing numerous opportunities and threats in portfolios, customized to our clients’ unique circumstances.

Our “Sailing in Uncharted Waters” investing approach can be summed up by six themes:

• Diversification with a balance of offensive and defensive measures, depending on the desired risk tolerance of our clients,
• Underweighting, or avoiding areas of higher future concern,
• A focus on higher-quality investment themes,
• Identifying and implementing buying opportunities (includes alternatives to stocks) that may be appropriate for more growth-oriented portfolios,
• A more defensive stance using different portfolio tools for more conservative growth and income portfolios, and,
• Utilizing select alternatives to traditional bonds and stocks.

~ Dax, Dennis, Glenn, Jason, John and PJ
(The SFG Investment Committee)