... never boils. In 2000 and 2007 many market pundits were delighted at the first rate cuts by the Federal Reserve. After all, in both instances the economy was good and many expected the Fed stimulus to inspire a new rally. While the philosophy was correct, the timing was wrong. The Fed was cutting rates because problems were cropping up, such as the technology capital expenditure collapse of 2001 and the financial crisis of 2008. Today, we see a "K" shaped economy where some have done very well, while others have done poorly. With the Fed now cutting rates, what does that mean? Let's discuss below. | |
Market Update - November 2024 | |
- During October, broad stock indexes fell. Financials, communications and energy sectors rose on the belief that the Fed has engineered a "soft" landing. That means no harsh recession after raising interest rates. Health care, consumer staples and real estate fell as interest rates rose following the Fed's September rate cut.
- All bond markets fell in October as interest rates rose following the Fed's aggressive 0.50% rate cut in September. There are many pundits saying this will encourage inflation, negatively affecting sentiment for bond ownership.
- Commodities rose during October, especially gold as inflation fears encouraged buying in the futures markets.
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Table 1: Market performance estimates as of 10/31/2024 (LIMW) | |
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Investors and mass consumers have different views of the economy.
Investors and members of the upper class are experiencing a very good economy. The stock market rallied strongly over the last 2 years and is well above the 2020 lows. Large companies captured most of the government stimulus dollars and demand for skilled labor such as doctors, nurses, electricians, plumbers, carpenters and engineers is quite high. High wages and excellent investment returns provided this demographic plenty of money to spend.
On the other hand, most consumers in the lower and middle classes struggled with only slightly higher wages, less labor demand and significantly higher expenses for food, rent and insurance. Employment as a percentage of the population continued to fall and the marriage statistics fell along with birth rates. This is not just an American phenomena, but is happening across the developed world.
Additionally, the lower and middle classes tend to have much smaller investment portfolios and as such are unable to offset spending inflation with investment returns. As a result, budgets tightened and reduced cash available to spend on discretionary items such as vacations, cars, phones and homes.
Let's review the evidence and discuss the implications.
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Evidence of the "K" shaped recovery | |
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Investor confidence that stocks will keep rising just hit the highest level since 1987. This is, of course, a contrarian indicator and tends to reflect the stock market itself. Investors "love" stocks at the highs and "hate" them at the lows. However, the wealthy tend to own most stocks, so when stock prices rise, the wealthy do better. That translates into higher spending on luxury items such as high end cars, vacations, second homes, and other items.
Inflation has minimally impacted the lifestyles of the upper class.
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Figure 1: Consumer Confidence: Expectations of Higher Stock Prices (Conference Board) | |
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Stock market performance since the 2020 pandemic has been driven by the outperformance of the technology sector. Remote work and online shopping helped companies like Microsoft, Google, Nvidia and Amazon, while stimulus money for immigrants supported the remarkable profits of health insurers, residential property managers, retailers and hospitals. These organizations benefited from the upside of the "K" shaped recovery.
The size of US technology companies is also amazing. Here is a chart comparing Nvidia's market capitalization to the entire Japanese stock market.
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Figure 2: Nvidia stock market chart comparison to the Japanese stock market: total market capitalization (Jeff Weniger) | |
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On the other hand, the lower and middle classes have struggled with inflation in places rarely considered a problem: auto insurance, property insurance, and food inflation. These components have aggravated many families living on budget. Since 2009, health care inflation and rent inflation have also plagued family finances.
One response to this stress is to default on debts. Auto loan delinquencies are currently at 15-year highs and rising. Commercial mortgage delinquencies are rising also hurting primarily small and regional banks.
When we look at their finances, spending and confidence, it is apparent that the lower and middle classes are not doing well.
Figure 3: Auto loan delinquency rate v. Auto loan balances (Arbor)
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Figure 4: Bank commercial loan delinquency rate by bank size (FDIC) | |
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Another point of pain for the consumers is the bifurcation of growth in the economy. The service sector in the United States has done very well helping government, academic, and health care workers with generous salaries and benefits. Meanwhile, the private sector has done poorly, especially the manufacturing industries where many are employed.
Figure 5: Purchasing manager indexes for service and manufacturing sectors (LIWM)
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Finally, the broad labor market is weakening with most of the losses falling on the lower and middle classes in the non-service sectors.
It is tough to be poor and middle class, but even tougher when the economy is slowing in an inflationary environment. This is a repeat of the stagflation from the 1970's.
Figure 6: Unemployment rate and Initial Jobless Claims (LIWM)
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Fed policy: ride'em cowboy | |
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The Federal Reserve gave us a big 0.50% rate cut in September from 5.25% to 4.75%. They were responding to lower inflation reports, banks' desire for lower rates to save their bond portfolios and governments' desire for lower rates to cut their interest expense.
Except it didn't work out the way they expected.
Interest rates fell in advance of the rate cut, but then bounced higher on fears that the aggressive rate cut might be inflationary. Our view is that it is too early to tell if this new Fed interest rate policy change is inflationary, yet. The bond market certainly is uneasy.
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Figure 7: US Federal debt yields at various future maturities (Wolfstreet.com) | |
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Bank investment losses are another headache for the Fed. Here is a chart from an FDIC report on unrealized losses at the banks. Banks and insurance companies focus their investment portfolios on bonds, typically. As the Fed and Congress pumped trillions into the economy with pandemic stimulus programs, the banks in turn bought bonds at historically high prices (i.e. low yields). As inflation picked up, those bonds fell in value (i.e. yields rose). As a result, banks incurred horrific losses on their investments.
One of the gifts to the banking sector during the 2009 financial crisis was a regulation that allowed them to separate "available for sale" versus "long-term" investments. Losses on long-term investments would not be counted as losses to the bank. So, today we have banks acknowledging they have massive losses on their investment portfolios, but record earnings because they are not required to recognize those same investment losses.
This long explanation tells you why the Fed is desperate for yields to fall. The Fed exists to protect and foster growth in the banking sector. Unless yields fall, these losses will not go away. That means the banking sector is weaker than it appears.
Figure 8: Unrealized investment losses by banks (FDIC)
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Even the Fed's analysts are raising alarm bells over the rising risk profile in the U.S. banking system. We are not forecasting another financial crisis, but recognize that profitability in the financial sector has been a bit optimistic. | |
Figure 9: Article highlighting Federal Reserve Bank research | |
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Finally, nobody seems interested in what the Fed is doing with their balance sheet. For years after the financial crisis and pandemic, analysts drew charts comparing the Fed balance sheet growth with the stock market.
You don't see that anymore because the relationship went into reverse in 2022.
The Federal Reserve has been steadily draining reserves from the banking system since 2022 and aggressively winding down the bailout program that followed bank failures in March 2023. That last program should be closed down by Nov 11, 2024, conveniently after the election.
Figure 10: Federal Reserve balance sheet (stimulus) components (FinanceLancelot). Notice the plunging magenta line for the BTFP.
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In addition to the Federal Reserve, other major central banks have been reducing their balance sheets to rein in stimulus and lower inflation. This analysis may not necessary be predictive, but it gives us a sense of the scale of global central bank pandemic stimulus programs and how much it has declined in aggregate since 2022.
This graph combines the central bank balance sheets of the United States, China, Japan and the EU in US$.
Figure 11: Central Bank Liquidity 2018-2024 (FinanceLancelot)
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In conclusion, the Federal Reserve has a lot of balls in the air and has so-far successfully balanced the needs of the bond market for lower inflation with the need to support employment and growth for the public. | |
The stock market has reached "ludicrous" speed | |
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For those entertained by science-fiction satire, you probably remember this scene from the movie Spaceballs. Darth Helmut wants to go from LIGHT SPEED, beyond RIDICULOUS SPEED, all the way to LUDICROUS SPEED. Technology growth stocks have retained suprisingly high valuations for years now. While not identical, there are many similarities to the late 1990's. Stocks are expensive in general, but tech stocks are especially pricey as they approach their own version of LUDICROUS SPEED.
A few months ago we introduced the concepts of "Double Counting" and "Double Jeopardy!" In the Double Counting scenario, investors can purchase stocks at low valuations and recessionary earnings levels. For the Double Jeopardy! scenario, investors are faced with high valuations and cyclically inflated earnings. The risk here is that the market can fall significantly if either the valuations or earnings crack.
As of October 2024, the forward price-to-earnings ratio on the S&P 500 has risen to 22.2, very close to the peak we saw in 2000 during the technology bubble. It is possible that between inflation and technological innovation, earnings continue to grow and that the Fed will save the market from every significant stumble as they have done over the last 20 years.
On the other hand, with the election concluded, perhaps the Fed will decide to get tough on inflation. Or the new incoming administration will decide to close the budget gap by cutting spending or raising taxes or both. There are many unknowns.
Which ever way it goes, the valuations we face today are definitely on the "high" side compared to other economic cycles and there is little room for error on the part of investors or regulators.
Figure 12: Updated Double Jeopardy analysis (LIWM)
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Figure 13: S&P 500 recently edged higher in 2024 (LIWM) | |
Bonds sold off as interest rates rose following the Fed's September rate cut. It is our view that a bottom is forming for the bond market subject to economic growth and federal spending plans over the next few quarters. | |
Figure 10: Aggregate Bond portfolio ETF (SPDR, LIWM) | |
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We are living through a "K" shaped economic recovery that has been very beneficial for the upper class and an ongoing struggle for the middle and lower classes. Despite Fed policy to slow growth, the stock market continues to grind higher. This helps the upper classes at the same time the middle and poor classes struggle with inflation. The spending value of the US$ has fallen ~25% since the beginning of 2019.
It is our view that inflation is falling and the economy is slowing into a recession. We expect volatility to increase, bonds to rally and stocks to be very choppy in coming months. It is unlikely the Fed will be able to cut rates significantly below 2.5% unless this slowdown becomes more serious and we see more bank failures.
As always, we welcome your feedback and are happy to discuss.
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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