Insights

The Economy Starts to Soften

Strategy

As we leave the 2^nd quarter there are more and more signs the economy is starting to look a bit weaker than earlier this year.  GDP has fallen every quarter since the middle of 2023.  The Atlanta Fed’s GDPNow is projecting Q2 growth of 1.5% which is down from the 3.9% originally reported.  Inflation was well behaved last month.  The Consumer Price Index (CPI) increased 0.0%.  The core CPI year-over-year index increased 3.3% vs expectations of 3.4%.  Consumers don’t feel as confident about the economy as the University of Michigan’s Sentiment survey declined from 68.5 to 66.  Retails sales likewise were lower, increasing 0.1% versus an expectation of 0.3%.  Higher interest rates have really hurt the housing market.  Housing starts fell from 1.36mm to 1.28mm.  Existing home sales were softer as well.  One of the biggest surprises was the weakening in the ISM Services data.  The index fell to 48.8 versus 53.8.  A reading below 50 means the service sector is contracting.  The final indicator to show a negative surprise was nonfarm payrolls.  They advanced 206k but last month’s increase was 272k and there was also a revision to the prior two months of -111k.  Lastly, the unemployment rate increased to 4.1% and is well above the cyclical low last year of 3.4%.   Maybe this will get Chairman Powell’s attention?       

While there are many signs the economy is slowing, we haven’t seen interest rates act like they believe it.  Treasury yields increased 20 basis points last quarter and are generally 50 basis points higher all along the curve for 2024.  Some of this has been a result of the hotter-than-expected inflation data in January and February and some of it has been caused by the various Fed Presidents’ comments regarding no need for a rate cut anytime soon.  The market expects two 25 basis point rate cuts this year.  While these pages have predicted recession in the past, we remain convinced the economy is slowing and the market is underestimating the severity of the slowdown.  This implies more than 50 basis points of rate reductions whereas the market expects two cuts of 25 basis points each currently.

One investment that provides an attractive yield with no credit risk, no premium risk and very good call protection is the discounted 15-year mortgage-backed security (MBS).   Let’s look at the 4.5% coupon MBS trading near $98.  The bonds have a 4.9 year average life and yield 4.90% versus 4.20% for a 5 year Treasury note.  Every mortgage that prepays goes back to the investor at $100 so the investor enjoys an additional bump to the yield.  These are backed by the government and have excellent liquidity. If an investor wants more prepayment protection, then buy the 3.0% coupon or 3.5% at an even larger discount.   Banks tend to be heavy users of MBS as do some mutual funds.   

Investment grade corporate bonds remain one of the most frequently used securities in the fixed income market and currently they are priced to perfection. We measure this by calculating the additional yield investors receive versus a like maturity Treasury (risk free) security.  The additional yield is called the “credit spread” and is currently 94 basis points.  This spread traded as wide as 170 basis points in 2022.  It widens and narrows based on the outlook for corporate defaults which in turn is a function of economic growth.  The spread spiked to 400 basis points during the pandemic for a very short time.  Liquidity is excellent and defaults are rare.  Financial issuers offer some of the best value.  As a reminder investment grade encompasses the following credit ratings: AAA, AA, A and BBB.  Roughly 50% of the investment grade corporate bond market is rated BBB. 

Our last idea is not new, but it is one that we have a very strong conviction towards.  Extend duration by buying longer term maturities with call protection.  There are many reasons why we believe this is the correct strategy.  Interest rates are the highest they have been since 2006 – 2007.  The economy is clearly slowing and that should force the Fed to cut rates in the coming months.  As the market looks for a rate cut other interest rates like Treasury and corporate bond yields will likely fall before the Fed moves.  As rates fall, bond market values increase.  Often the initial move lower is very fast and catches people off-guard.  Now is the time to extend maturities while rates are at these levels.

Observations and Outlook – Keeping an Eye on the Consumer  

At the end of the second quarter, the consumer, who had an updraft of confidence mid quarter, saw consumer confidence sink.  Consumer expectations for the next six months fell and only 12.5% of consumers anticipate that business conditions will improve in the next six months.  That is the lowest reading since 2011.  The impact of higher borrowing rates, or possibly reduced economic confidence is having an impact on buying patterns.  Specific areas of consumer pull-back include cars and major appliances. 

"Broadly, absent significant real wage gains, a large swath of the population is positioned for future struggles."

As we’ve discussed before, consumers are increasingly relying on accessing debt to support spending.  Since the start of the pandemic, credit card balances are up 25% and total consumer debt has increased $3.4 trillion over that time, bringing total household debt to $17.7 trillion.  It is worth repeating that this increased debt burden comes at a time when the financing rates are the highest they have been in quite some time, making the elevated debt burden doubly burdensome.  A recent New York Fed report showed that 6.9% of credit card debt has become seriously delinquent last quarter, up from 4.6% a year ago.  For card holders between the ages of 18 and 29, nearly 10% of balances are seriously delinquent.  As an update to the state of auto loan environment, roughly 2.8% of auto loans are 90 or more days delinquent (that translates to roughly 3 million cars!). Adding to the debt picture is the fact that last quarter $16 billion in home equity loans were originated, the largest increase since 2008.  The total amount of home equity credit stands at $580 billon, the most in nearly 15 years.  The referenced New York Fed piece suggested that “one observable factor that is strongly correlated with future delinquencies is a high credit card utilization rate.”  A stressed consumer with large debt balances may turn into delinquencies and defaults and it could result in a strain on financial institution profitability.  A rapidly emerging “convenience” that will make consumer debt burdens more difficult to track is the “Buy Now, Pay Later” (BNPL) services, which allow consumers to split purchases into smaller installment payments.  This “phantom debt” is not reported to the credit agencies, and it is expected to grow to $700 billion by 2028.  We will offer a few quick statistics from a Bloomberg News Harris Poll on why it seems that BNPL services are like throwing a boulder to a drowning person.  43% of people who use BNPL platforms are behind on payments.  Nearly a quarter of respondents agreed with the statement that their BNPL spending was “out of control.”  Over a third of users turned to BNPL after maxing out their credit cards.  42% of those with household incomes above $100,000 report being delinquent on their BNPL payments.  54% of respondents said the service enabled them to spend more than they can afford.  Broadly, absent significant real wage gains, a large swath of the population is positioned for future struggles.     

A stretched consumer will only be sustained if jobs and real wages remain robust.  That appears to be unlikely.  As touched on earlier, the service sector as measured by ISM Non-Manufacturing has contracted in two of the past three months, following a period of 15 months of consecutive growth.  The manufacturing sector, as measured by the ISM Manufacturing Index, has generally been contracting for much of the past couple of years.  The recent contraction in both the manufacturing and service sectors does not suggest support for job growth.  The strength of the formerly “unstoppable” job market may be waning.  May saw the number of available jobs increase to 8.14 million jobs, but April was a disappointment with a downwardly revised 7.92 million jobs.  Many of the job openings were government jobs so read into that as you will, they are still jobs, but the economic impact of those jobs in their totality may be less than job opportunities in other areas (that is our interpretation of analyst discounting of government sector jobs).  Employers don’t have to tighten their belts too much more to turn the previously mentioned 1.2 jobs per seeker down to .8 jobs per seeker.  Although early indications from quarterly earnings season have come in fairly well, many companies have highlighted a stressed consumer.  If consumers pull back, requiring discounting by businesses, the job market could turn quickly.  Employed people may sense the change in the balance of the labor market.  The “quits rate,” which represents people who voluntarily leave their jobs was 2.2, the lowest reading since 2020.  In recent comments by Fed Chair Powell, when speaking out of the “dovish” side of his mouth, has said that he would sacrifice some amount of progress on the inflation goal if it meant they would get ahead of a meaningful downturn in the labor market.  The employment environment will seemingly drive Fed policy from this point forward in this cycle.    

The market largely assumes the first Fed rate cut will be in September, and again before the end of the year.  The job market is clearly more balanced than it had been, and inflation is trending lower, but to be confident that a rate cut is consistent with the Fed’s dual mandate, a clear pattern of progress on the inflation side of the dual mandate is needed to support a change in policy.  The market may be mistaking its wants for the Fed’s wishes.  The Fed does not want to lose credibility by cutting too soon and allowing inflation and market euphoria to resume, especially when the job market is robust by most historical measures.  While we are in the messy middle of the economic cycle, it is likely that we will see some prints of economic news that are unexpectedly positive, so a September cut would require nearly uniformly bad economic news and unwavering progress on inflation.  We think the bias in Fed policy is that “higher for longer” remains intact.  Cutting rates too soon means that Powell’s guidance on when inflation is beat (when people stop talking about it) isn’t likely achieved.  In July, Chair Powell said that “because the US economy is strong and the labor market is strong, we have the ability to take our time and get this right.”  Going from a comment that things are going well and that the Fed can be patient, to cutting rates in a two-month window seems aggressive and hopeful.  

We expect that the market reaction to a resolute Fed and a deteriorating consumer will be that bond yields fall, as is historically the case prior to a Fed easing cycle and prior to the official call of a recession.  It may be the case that consumers need to feel bad to wring inflation expectations out of economic expectations.  Medicine that tastes nice may simply be an elixir, where it may take the bad tasting stuff to get the job done. 

The political landscape may heavily weigh on whether near-term Treasury gains, especially in the long end of the yield curve, have staying power.  Treasury Secretary Yellen recently said that their outlook for higher interest rates over the long term makes it “more challenging to keep deficits and interest expense under control.” She went on to say she would be concerned about the US interest cost burden if inflation-adjusted interest payments relative to GDP drifted above 2%.  The ratio jumped last year but the Administration sees that metric stabilizing around 1.3% over the coming decade.  It seems to suggest that R*, the neutral rate of interest rates, may be expected to be higher in the future than was the case in the recent past.  Efforts to erode the use of the petrodollar and to de-dollarize global trade could feed into reduced demand for US Treasuries.  Out of control deficits may also cause the supply of US Treasuries to exceed demand.  As the deficits persist and the debt grows, especially if economic growth does not keep pace, the risk of US debt will increase, demanding that the interest cost of our formerly “risk-free” Treasuries increases.

"Government revenue is a precious resource."

Our increased borrowing costs will be well deserved.  The political circus that will absorb the news cycle into November, and possibly beyond, may cloud what an unserious lot we’ve become.  As a “pet” example of how irresponsible we have become, the latest student loan proposal involves cancelling student loans for people with undergraduate loans that are older than 20 years, or 25 years for graduate borrowers, and who are on income-based repayment plans, with no conditions attached.  The plan will be a windfall of more than $25,000 for roughly 750,000 borrowers.  Although it sounds nice for those being rescued, the problem many people may have with the plan is that the average household income of this cohort is $312,976.  Government revenue is a precious resource.  We are in trouble if we don’t return to fiscal sanity.  The best prospect for returning to fiscal discipline in the next election may come from gridlock.  If the Biden Administration remains in power, it is likely that the 2017 tax cuts will begin to expire in 2025.  That could raise revenue but the propensity to spend over the past three and a half years has been substantial.  You know you are doing something unique when one of the fathers of Modern Monetary Theory (where a reserve currency economy can print money to buy their own Treasuries without limit), Warren Mosler, has said that a 7% deficit as a share of GDP, at a time when the US is not in recession, “is like drunken-sailor level of government spending.” Coming from him, that should be a sobering comment.  Former President Trump also had the gift of spending.  If he wins the race, there is a scenario where gridlock causes the 2017 tax cuts to roll off, while new tariffs result in additional revenue.  Sure, tariffs are essentially trade friction and a form of tax, but they may be more broadly distributed streams of revenue than what is politically feasible.  The real deficit expanding risk is a wave election (an idea we may explore next quarter). If that happens, we are pessimistic about performance of long-term bonds if a wave election results in profligate spending.  Other sources of risk for bond returns involve tight risk spreads in the corporate bond sector (meaning the incremental yield you earn for corporate bonds is small relative to the normal relationship, as compared to a like-term Treasury) and large amounts of institutional allocation to private debt funds, where in many cases, the funds determine the value of their holdings (which seems ripe for trouble if the economy slows and defaults increase). 

Base effect comparisons of CPI in the months of July and August could present readings that will appear as if the Fed’s actions are not able to get inflation under control.  If that occurs before the consumer or the job environment takes a turn for the worse, it may offer an attractive buying environment for bond investors.  The window for this opportunity appears to be shutting.  We continue to encourage a quality bias in portfolios as spread widening could erode returns in 2024 or 2025 if we find ourselves in an environment where bankruptcies are on the rise.  The foundation of the longer bond component of our strategy is based on a normal political environment and a traditional slowing of the economy.  Yields are near the highest they have been in 15 years and starting yields are typically very predictive of bond returns over the course of the life of a bond.  This will be the last quarter that we conclude with the following sentence: a wave election represents the most likely “known unknown” that would significantly change our bias and market assumptions.   

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