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AAM Viewpoints - Credit, Consumer and Consumption: Dusk in Versailles?


 

 

After an eventful third quarter, the markets anticipate the coming fourth quarter in a heightened state.  The subdued volatility in the equity markets as measured by the VIX index and the similar measure in the Treasury Market Move Index did not represent the markets' performance. The US Treasury Index saw a quarterly total negative return of 3.06% while the S&P 500 saw a total negative return of 3.20%. 

As we sit, the expected shutdown of the US Government was averted for 45 days. Seems the pattern of politicians’ mantra of why address issues today that you can put off until tomorrow is alive and well. To affirm this, recall there have been 20 shutdowns over the last nearly 50 years that averaged 8 days. At some point we will see the story of The Boy Who Cried Wolf become reality, but it appears not today.

As we will point out, the coming clarity on events and market reactions appear to us to be akin to being dusk in Versailles. For those not familiar, during the summer, every Saturday evening, there is a fireworks display. The anticipation of the fireworks begins at dusk and thusly we see some coming realizations being addressed in the fourth quarter. 

We are seeing the four Ps of the Federal Reserve’s interest rate hike cycle playing out according to the script, though the length of the scripts seems to change. Experience has taught us that staying true to this script and paying attention to what this means for markets and economies is inevitable. The question is when and the degree of the ramifications of interest rate hikes. 

For a primer, the four Ps are as follow:

  • Peak inflation and peak rates.
  • Pause in hiking rates.
  • Pivot to cutting interest rates.
  • Patience is required and a pragmatic approach to assets.

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While the markets are somewhat similar to the path that the Fed is saying in their projections for interest rates moving forward as indicated by futures of global central bank anticipated rate hikes saying they are about 95% done, one must at least consider this could be a bit off in accuracy. The component about futures and predictability is they are fluid and change with little memory of their errors. Recall at the end of 2021, the Fed Fund Futures said expectation was for a 0.82% Fed Funds Rate. It ended up at 4.50%! As Bob Uecker would say, just a bit outside. 

To drive our bias, consider the market’s estimation of inflation and interest rates since 2020. 
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Source: Bianco Research, LLC

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Source: Bianco Research, LLC

We have a constant bias to underestimate these two measures. By concluding that we are done may ultimately be correct, however the error in investing in a binary solution can be costly. 

Longer term, we are at our long-term average, but income and equity investors might want to pay attention to the variance (standard deviation) to arrive at the 4.50%. While we do not see the inflation high levels getting back to the 1970-1980 area, we do see elevated inflation above the Fed’s comfort level. 

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The ramifications of elevated inflation and lagging Fed reaction to it is showing up in many areas. 

  • Banks' lending standards have become restrictive to the level where recessions in the past have occurred.
  • Inverted yield curves at levels not seen in nearly 5 decades and the duration of some inversions have reliable to the 100% level of an onset of a recession in 12 months.
  • Increased bankruptcies have grown for 13 months in a row, not a sign of a healthy economy.
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Source: Bianco Research, LLC

  • Increased defaults are occurring on a slower path, but the increase is real. Also, increasing downgrades to upgrades in corporate debt are showing up at a 2 and 3 to 1 on a weekly level. 
  • The Bloomberg US Aggregate Bond Index has now not seen a new price high in 38 months and is nearly 18% off its high price. At this point you will need to see almost 200 bps in decline to see this get within a shot of doing so. The only way this occurs is a sharp credit seizure and plummeting economic data, which could occur as a negative feedback loop takes place, but this does not seem imminent. 

Perhaps the most befuddling component is that in light of this, the spreads on investment grade and high yield to Treasuries has not blown out to represent the elevated credit risk as shown by the two charts below. 

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As a result, there is a broad level of apathy in holding credit and anchoring the price on both indexes at the 90-dollar level. As if a gift from the Heavens, the household and nonprofits holding of Treasuries and government debt has swollen to all time highs at $2.3 trillion. 

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This massive risk off move by households and non-profits is affirmed by all-time high in money market fund assets. For the first time, investors are paid to be on the sidelines or have elevated cash proxies in their portfolios. 

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The most updated household net worth (2Q 2023) and total cash equivalents shows a healthy but draining of some of their immediate liquidity. 

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We need to pay close attention to the consumer in the US and across the globe based on their importance to growth in the economy. As a reminder, here are the various domestic consumption rates across the globe. 

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To show the changes in the US economy based on the consumer, government, private investment, and import/exports, one sees that the governments have had an elevated impact. With the debt ceiling and budget agreements in a perpetual state of dysfunction and uncertainty, the growth coming from this will begin to be challenged.  We are seeing many professionals point to private investment picking up which seems likely, though higher wages, potential challenged consumption and hurdles in operating margins could possibly limit this. 

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While we see some contradictions in the sales and sentiment to the markets pricing, one data source caught our attention. The OECD has a data point of US retail sales volumes (not actual sales values) and 2023 is negative year over year. This is very impactful as we see its correlation with a recession is very high.

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While we see many slowing and challenging economic conditions, the shiny silver lining is the liquidity backstop and the pricing of the precession inherent across various fund managers, households, and corporate balance sheets. What appears to us currently is that the reality of some of the consternation and anxieties will come to fruition to a certain extent in the fourth quarter.  While many are sitting in an elevated liquidity position in their portfolios, enjoy the firework show, but be keen to look for entry points in various assets. We continue to favor value and quality across asset and debt classes to complement the liquidity in portfolios. 

CRN: 2023-1002-11152 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

 


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