Update on the Economy and Investment Markets 8/19/2023

Welcome to the Stearns Financial Poolside Chat.

Equity markets stumbled during the first half of August in response to lackluster second quarter corporate earnings results.  Stocks came under further pressure with the release of the Fed’s July meeting minutes – which confirmed not only the possibility of further rate hikes but included a comment that “most participants continued to see significant upside risks to inflation, which could require further tightening of monetary policy.”  This news sent stocks down and treasury yields up.

While the S&P 500 was down 3.9% in the month of August through Wednesday, it was still up almost 16% year-to-date.  Thus far, earnings are down 5.2% year-over-year according to FactSet, with 84% of S&P 500 companies having reported through August 4th.  While the decline is noteworthy, it is important to recognize that it still beat analysts’ expectations.  Some of the larger technology names announced mixed results and have faced some pressure on their stocks in recent weeks, which has been a headwind for the broader market.

Following the release of the FOMC minutes, the yield on the 10-year treasury reached its highest level in 15 years at 4.3% on Thursday morning. It wasn’t that long ago when the ten-year treasury hit an all-time low of .318% (in March of 2020) as investors flocked to safety at the onset of the pandemic.  

Longer-dated treasuries have also seen a nice uptick in yields, with the 30-year rising to almost 4.4%.  Like the 10-year, outside of last October, this is the highest level in over a decade.  The 30-year was down to .702% during the pandemic, breaking the historic threshold of 1% for the first time in history. It’s therefore no surprise that there has been a corresponding rise in 30-year mortgage rates, which now top 7%, the highest level in 22 years. Rising rates have slowed mortgage applications, but prices remain high because of limited supply – due in part to existing homeowners’ unwillingness to leave their low mortgage rate homes and swap them for “less house” at current rates.  

Following better-than-expected U.S. GDP growth during Q2, Q3 GDP growth is expected to slow. There is a lot of time left in the quarter, but one forecast (which is really more of a point-in-time projection that can exhibit volatility) has GDP growth at over 5% for the quarter. The GDPNow model produced by the Atlanta Fed is a model-driven estimate based on economic data. It is important to note that GDPNow is not an official forecast of the Atlanta Fed. The below chart shows the current GDPNow estimate compared to the latest economist forecasts. Some of the inputs showing strength early in the quarter are personal consumption expenditures and industrial production. A comparable forecast from the St. Louis Fed currently projects GDP growth of a paltry 0.59%. SFG expects the Atlanta GDPNow forecast to pull back significantly over the next month, but it will be interesting to see if economists’ estimates continue to rise as the U.S. economy continues to exhibit resiliency.

In contrast to the economic growth in the U.S., other countries around the world are not experiencing the same resiliency. It was announced this week that the Netherlands’ economy is officially in recession, joining Germany (which announced a recession in Q1 of this year).

More importantly, for the global economy, China is facing significant challenges. Economic data coming out of China has been worrisome, with retail sales and industrial production falling short of expectations in July. China is also experiencing falling prices in some areas of its economy, and a real estate market that is in turmoil. Shadow banking – that is, lending that is unregulated, risky, and often uses depositors’ assets promising higher returns, is making its way back into the headlines. 

China’s shadow banking sector is valued at a whopping $3 trillion (some estimates put this number closer to $10 trillion) – similar in size to the entire GDP of Great Britain. One of the largest Chinese trust companies that is part of this system has missed payments and a large developer is on the brink of default, raising contagion concerns that, in a worst-case scenario, bank lending may come to a halt. The rising concerns have put pressure on the Chinese stock market and will force President Xi Jinping and the People’s Bank of China to act. The question will be whether they can provide sufficient support to stem fears and prevent a liquidity and economic crisis.

Inflation Update

July inflation data came in mixed. Headline inflation (CPI) rose to 3.2% on a year-over-year basis in July compared to 3% in June. However, this was below the market expectation of 3.3%. CPI continues to be driven by shelter costs, which were up 7.7% year-over-year and 0.4% month-over-month. Shelter costs accounted for 90% of the overall increase from the previous month, according to the U.S. Bureau of Labor Statistics. As discussed previously, shelter is typically a lagging indicator, so we would expect it to continue to decline in the coming months.

Fortunately, core inflation (which excludes food and energy) continued its downward trend, falling to 4.7%.  Also, the latest PPI (producer price index for final demand) data came in above expectations at 0.3% month-over-month compared to an expectation of 0.2%. PPI had been flat in June. With this mixed data, we expect the Federal Reserve to pause in September and not act regarding the Fed Funds Rate at their next meeting, but another hike this year is not yet off the table.

SFG’s Take: Staying appropriately invested and diversified makes sense in this investment landscape. Equity markets could be choppy the rest of the year, as higher yields make bonds more attractive to investors and as corporate earnings continue to face pressure. We do not believe the Federal Reserve will hike rates at their September meeting based on current data.  We will continue to monitor the developing situation in China.

Key Points to Consider

Consumer Sentiment

Consumer sentiment declined slightly in August. The index, tracked by the University of Michigan, declined to 71.2 from 71.6.  The University of Michigan’s Director of Surveys stated: “In general, consumers perceived few material differences in the economic environment from last month, but they saw substantial improvements relative to just three months ago.” Slowing inflation has boosted sentiment this year. However, with gas prices rising and student loan repayments restarting in October, there could be pressure on sentiment in the coming months.

Gas Prices

Gas prices hit a 10-month high this week, with the national average for a gallon approaching $4.00 as of Monday. This is slightly below where gas prices were last year at this time; however, it could affect consumer sentiment and inflation as we approach the Labor Day holiday. Earlier this month, Saudi Arabia announced it would extend certain oil production cuts by a month through September, which will pressure global oil markets. The cuts from Saudi Arabia are on top of cuts announced in June by OPEC+ that will last through 2024. U.S. production this year is expected to exceed daily production in 2019 prior to COVID, but it is not anticipated that domestic production will be able to completely offset the cuts from other countries. 

Frequently Asked Questions

Q: I’ve read that the resumption of student debt payments could harm the U.S. economy, since that money won’t be available for consumer spending. How much harm is likely? How does that compare with student debt forgiveness which could put more money in consumer’s pockets to spend?

A: The continued extension of student loan forgiveness after the pandemic will end later this month. Interest will begin accruing in September and payments will begin in October. Tens of millions of student loan holders will begin payments totaling over $100 billion. Many higher-debt student loan borrowers will see their credit scores fall and a small increase in credit card delinquencies is expected.

A senior economist at Jefferies estimates at least 40 million borrowers will resume payments with an average monthly bill of around $400, based on Federal Reserve surveys and other government data.

Yes, this will pull some income out of the U.S. economy that could be spent on other things, but not enough to tip the U.S. into recession, at least not in and of itself. It does, however, put pressure on an estimated 20% of American consumers, who are experiencing dwindling savings rates, rising credit card debt and an uptick in auto loan defaults.

On the flip side, the resumption of student loan payments is good for the federal budget deficit at a time when maturing government debt and higher interest rates and are increasingly pressuring the U.S. treasury.  Most of the U.S. debt will have to be refinanced in the next three years, at much higher interest rates, with approximately 30% ($6.7 trillion) maturing in 2023 alone.

Economists believe much of the ripple effect of student loan resumption will be concentrated in a few industries, notably e-commerce, bars, restaurants, and some major retailers.

The plan to have 26 million Americans’ student debt wiped out (more than $400 billion) was struck down by the Supreme Court last Friday. The $73 billion for these student loan holders is estimated to shave a quarter percentage point off economic growth in the coming year.  Again, not enough by itself to cause a true national recession but a further headwind to consumer spending. 

SFG’s Take: Reduced spending on goods and services resulting from the resumption of student loan payments won’t by itself make a serious dent in the $26 trillion U.S. economy.  We don’t, therefore, view this issue as a huge yellow flag, however, it does contribute to the 2024 recession watch checklist and its ripple effects will be something we continue to monitor.

Maui

The unimaginably tragic event that has unfolded in Maui, with the loss of life anddestruction of Lahaina, is an issue that weighs on the minds of all Americans.  We have had numerous clients ask us how they can help. Below are a few of the organizations that are supporting the recovery efforts:

• Hawaii Community Foundation (Maui Strong) https://www.hawaiicommunityfoundation.org/maui-strong
• Maui United Way https://mauiunitedway.org/disasterrelief
• Maui Food Bank https://mauifoodbank.org/ (Hightower has made a donation to the Maui Food Bank)
• American Red Cross (Hawaii Wildfires) https://www.redcross.org/donate/hawaiiwildfires.html/

Meet Your Team

In this issue we talk with Libby Stafford, who has been with SFG for 20 years, and has done nearly every job in the company!  Libby works in our Greensboro office.

What is your role at SFG, and what services do you provide to our clients? My title is Director of Client Engagement and Business Development, which means I help clients who are transitioning from other firms or those that are new to investment management.  I also assist with financial planning.

What brought you to this area of the country? I am a native North Carolinian, born and bred here. What’s your favorite thing about where you live now, or where you’re from? Greensboro is the perfect size for me.

Tell me about your family – where did you grow up? I grew up in Eden, NC, as an only child. Who was/is your favorite relative, aside from Mom or Dad? My mom’s sister, my Aunt Evelyn, a great mentor, and friend, as well as the very best aunt.

What was your first job? I worked in the office at A&H Wayside Furniture in Reidsville. Any special lessons from it? I gained a lot of experience dealing with people on a professional level at a young age.

Early bird or night owl? I’m definitely an early bird – up at 5 AM and exercising for an hour every weekday. (Same thing, just a bit later on the weekends.)

If you could snap your fingers and become an expert in something, what would it be? I can’t pick just one: personally, it would be watercolor painting; professionally, it would be financial planning; and someday, it would be becoming a life coach.

What’s one thing you’re currently trying to make a habit, or one skill you’re trying to learn/hone? Again, can’t pick just one: I love working with watercolors, and I’m always trying to be a better financial planner.

Dogs or cats, or both – or neither? Neither for me. Coffee or tea? Coffee. Beach or mountains? Beach!

What was the first concert you ever attended? Brace yourselves – it was Alice Cooper! (Followed by Donny Osmond – how’s that for variety?)

What’s your favorite local restaurant? 1618 on Friendly, but I also love their wine bar on Battleground. Your favorite thing to do outside of work? My first favorite thing to do is to hang out with my sweet husband – then cooking, trying to learn to paint with watercolors, and exercising.

What’s your favorite part of your job? Helping clients achieve their goals is very satisfying, and the reason I still love this work, along with learning something new every day!

Summary

Many factors still indicate a slower growth scenario for the U.S. and global economy, even though an overall soft landing is increasingly likely. Rolling recessions in select sectors may continue, but with less severity.

Forward-looking stock returns are likely to be good, but not great, given the balance of headwinds and tailwinds currently in play. Now is not the time to be a hero (overweighting what has gone up the most year-to-date), but also not a time to be overly cautious.

Wildcard risks (low probability, high possible impact) discussed in this, and previous Chats remain and suggest some caution. Still 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)