Ladies and gentlemen, the weekend! In this space each week, Greg and I share some of our favorite articles, notes, and graphics from the past week along with our commentary. Please feel free to provide feedback and forward along to others if you enjoy. We appreciate you taking the time to read. 

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U.S. Economy: Receding Recession Expectations

“One of the more unexpected developments this year is that a recession has yet to rear its ugly head. Here we are, approaching three-quarters of the way into 2023, and the totality of economic data arguably continues to confound what was perhaps the most widely anticipated economic downturn on record. With [5.25%] worth of cumulative Federal Reserve rate hikes in the books, the U.S. economy may still not be completely out of the woods, but signs are pointing to another positive performance for third-quarter real gross domestic product (GDP) as well (more on that later)...

The above table underscores how the '2023 experience' has essentially been the opposite of last year’s. While real [gross domestic product] GDP has been enjoying growth of around 2%, [gross domestic income] GDI has either been negative or just barely positive.

However, another way of looking at economic activity is to average real GDP and GDI together, a component the BEA produces as well. Thus far in 2023, this average has produced basically no growth in Q1 (+0.1%) and a more modest 1.3% reading for Q2.

Conclusion

So will the real economy ‘please stand up?’ That brings us to where Q3 activity is. According to consensus forecasts, real GDP for the July–September period is expected to post another 2% performance, but the Atlanta Fed’s GDPNOW gauge has growth surging to 5.6%, as of this writing. Either way, it would appear the recession may have to wait yet again, with all eyes turning to how this year ends and 2024 begins.”

This was a good breakdown of the dislocations rippling through the economy between the growth of producing goods & services and the growth of overall income. We had a stretch of two negative quarters of output in 2022 that typically signifies a recession; however, quite a few other economic measures including the labor market and personal incomes were doing fine. Therefore, the National Bureau of Economic Research – the official arbiter of economic recessions – has not deemed that period a mild recession due to the advancement of other economic factors (income, unemployment, production, sales, and spending).

This year has seen the whipsaw effect. Output (GDP) has recovered and showed steady growth, but income (GDI) is wavering. 

An Important Shift in Fed Officials’ Rate Stance Is Under Way

“For more than a year, Federal Reserve policy makers were unanimous that they would rather raise interest rates too much than too little—that is how serious they considered the threat of persistently high inflation.

That is changing.

Some officials still prefer to err on the side of raising rates too much, reasoning that they can cut them later. Now, though, other officials see risks as more balanced. They worry about raising rates and causing a downturn that turns out to be unnecessary or triggering a new bout of financial turmoil.

The shift toward a more balanced bias on rates is driven by data showing easing inflation and a less overheated labor market. In addition, the unusually rapid rate increases implemented over the past 1½ years are expected to continue crimping demand in coming months.

Fed officials raised rates at 11 of their past 12 meetings, most recently in July, to a range between 5.25% and 5.5%, a 22-year high. They appear to be in broad agreement to hold interest rates there at their Sept. 19-20 meeting, giving them more time to see how the economy is responding to increases.”

Nick Timiraos at the Wall Street Journal has been a must-read on Fed policy moves. He’s been at the forefront of signaling changes to the market before meetings and allowing Fed Chair Powell to reiterate stances at press conferences rather than breaking news and surprising markets.

A rate increase next week was already likely a longshot. Probabilities have been ranging in the single digits for a month now.

However, there looks to be an unofficial pivot away from further increases. The probability of an interest rate increase at the FOMC meeting in November has dropped from 47% one week ago to 33.5% today. That’s a big shift from June’s hawkish rhetoric.

Profit margins continue to defy the skeptics 🤑

“Recent market gains can be attributed to the outlook for earnings growth. And some of that expected earnings growth can be attributed to what’s arguably the most unexpected development in the corporate world over the past two years: The resilience of profit margins.

As inflation rates surged in 2021, analysts were convinced rising costs would crush profit margins.

But the opposite happened as profit margins actually rose to record levels. During this period, many companies were able to pass higher costs to their customers through higher prices. Combined with improved operating efficiencies, this dynamic led to record profits. It was a reminder that it’s dangerous to underestimate Corporate America…

As such, there’s a thinking out there that if high inflation helped expand profit margins, then low inflation should eventually lead to contracting margins.

But not everyone is convinced margins are sure to contract — even with inflation cooling. In fact, the Wall Street consensus is for margins to continue to expand in the coming quarters.

Among other things, analysts expect companies to benefit from productivity gains yielded from operational changes made in recent years.

‘From here, efficiency gains — which have been non-existent for the last 10 years — via new tools like AI and robotics could create an even more labor light benchmark, a key positive for S&P 500 margins,’ BofA’s Savita Subramanian argued on Thursday.

She shared this eye-catching showing how revenue per worker has been improving.”

If interest rates stabilize in this range, the stock market needs to show earnings growth to rally from here. Profit margins have been incredibly resilient as companies have passed on inflation to the customer. Interest rate costs have (so far) been mitigated due to refinancing efforts and hedging over the past few years.

Capital expenditures and technology advancements should lead to productivity growth, which has stalled over the last 10-15 years. That’s a longer-term solution that looks to be improving recently.

However, investors still need to be cognizant of the earnings yield for their equity portfolios.

“Mortgage rate locks for second homes are down nearly 50% from pre-pandemic levels, compared to a 33% drop for primary homes.

Mortgage-rate locks for second homes were down 47% from pre-pandemic levels on a seasonally adjusted basis in August, compared to a 33% decline for primary homes. August marks the 14th-straight month that second-home demand has hovered at least 30% below pre-pandemic levels, as high housing costs and limited inventory deter would-be buyers.

That’s according to a Redfin analysis of Optimal Blue data. A mortgage-rate lock is an agreement between a homebuyer and a lender that allows the homebuyer to lock in an interest rate on a mortgage for a certain period of time; roughly 80% of rate locks result in purchases.”

Thanks for reading. Have a great weekend!

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