INSIGHTS

On August 12, 2024

AAM Viewpoints — Rorschach’s Economy

It’s a confusing time in the economy and markets. While financial markets boom and the administration boasts its economic record, 55% of consumers surveyed by The Harris Poll believe the economy is currently in the midst of recession and 49% believe unemployment is at a 50-year high. Official data from the Bureau of Labor Statistics shows that the nation’s unemployment rate has been at 4.3% or lower for 33 straight months — the longest streak in 55 years. This dichotomy between soft and hard data has been emblematic of the economy so far this year — that growth has been slowing from a high base while data has been noisy.

We think recent market action surrounding the dollar vs yen and the extreme pricing for Fed rate cuts in the wake of July’s jobs report is a great example of this. The largest singular contributor to the increase in unemployment in July was for workers on temporary layoff, while the Bureau of Labor Statistics reported 436,000 workers were unable to work due to poor weather. The Federal Reserve Bank of San Francisco’s Weather-Adjusted Employment Model estimates July’s 114,000 job additions were understated by about 34,000. This suggests there is a decent likelihood of an August snapback report like what occurred in April and May this year.

Some see a rocketing stock market; others see a rally driven by just a handful of companies. Periods of strong growth can be due to a more dynamic, less rate-sensitive economy and simultaneously explained purely by extraneous factors, as demonstrated best in the summer of 2023 when growth of 4.9% was widely attributed by market commentators to Taylor Swift and her world tour.

With a market hyper-focused on the Federal Reserve and the timing for rate cuts, recency bias reigns supreme. This makes it important to look under the hood, examine the data in totality, and separate the noise. After three years of high inflation and continued high prices, consumers are still spending, but have become much more price conscious. The “Any Product at Any Price” phenomenon we have seen over recent years is over, which is a major win for the Federal Reserve.

For a data-dependent Federal Reserve looking for the next move in rates to be down, data has moved convincingly in their favor after a burst in the first quarter. Core inflation has moderated significantly from the levels seen in the first three months of the year, and there are early signs that the services sector has entered a more sustainable path of disinflation. For the labor market, the ratio of job openings to unemployed workers has fallen from 2x in March 2022 to 1.2x in May 2024, the same ratio seen in February 2020. On the growth side, nominal economic growth has normalized toward the average rate of growth seen in the five years preceding the pandemic.

With the normalization seen within the economy, the Federal Reserve has a much better justification to begin the normalization of monetary policy. The economy no longer needs interest rates at 5.50% when growth is around trend, alongside a balanced labor market and a declining rate of inflation. In totality, the Fed has the data it needs to telegraph a September rate cut at Jackson Hole in August and reduce interest rates one or two more times in 2024 in 25 basis point increments.

That’s not to say we should expect a return to the zero-bound on interest rates seen in the 14 years after the 2008 Great Financial Crisis (GFC). Unlike that period, the global economy is amid an era of fragmentation and conflict — with a prioritization of domestic resiliency over cheaper prices — while certain areas of domestic consumer spending are in a period of structurally higher inflation. There are also notable differences in the structure of the economy today compared to both the post-GFC period and previous rate hike cycles.

Today, more than two-thirds of GDP and four in five private sector jobs in the United States are related to services, which are inherently less sensitive to interest rates and less prone to the boom-bust cycles seen in manufacturing. The Institute for Supply Management’s Purchasing Manager Indices (PMI’s) for manufacturing and services display this clearly. The services survey has been in contraction for just three out of the 29 months since the Federal Reserve first raised interest rates, while the manufacturing survey has been in contraction for 20, including a 16-consecutive-month contraction — the longest streak since 2001.

On the income side, the economy isn’t as reliant on the strength of the labor market to support growth. Less than half of the $24 trillion in total personal income now comes from wages and salaries, as the share of interest income, dividends, and transfer payments — such as Social Security — has doubled from just 15% in 1959 to 31% in December 2023. While a strong labor market remains a key ingredient for robust growth, in the modern economy, incomes and spending aren’t as purely dependent on wage income as in the past.

We think this diversification of income and the growing portion of the US economy claiming Social Security benefits are significant contributors to the resilience we have seen over this cycle and good reason to see the likelihood of recession as low. Today, there is a population of 71.7 million people receiving Social Security or Supplemental Security Income in January 2024 – just 6 million fewer than the number of workers over 16 that were paid at hourly rates in 2022. Effectively, annual Social Security COLAs (cost of living allowances) now have a similar — if not larger — impact to aggregate consumer income than any potential increase to the Federal Minimum Wage. This gives the economy a better ballast in the event of weakness but limits the magnitude of what the Fed can do in terms of rate reductions.

That said, the question for next year is how many times the Federal Reserve cuts, rather than if they will cut at all. This is a meaningful difference when analyzing the outlook for markets over the next 12 to 18 months. A Federal Reserve that pivots toward incrementally supporting growth is a significant boon for numerous industries in the U.S. economy, many of which have had close to no contribution to the returns we have seen over the last 18 months and are now seeing real signs of a much-awaited profit recovery. Recent data show 81% of S&P 500 companies have beaten estimates for second quarter earnings, with profits growing 12.7% relative to expectations of 8% at the start of the quarter. Earnings have grown 7% outside of the “Magnificent Seven” — officially ending an earnings recession and providing an important fundamental base. We believe a return to broad-based earnings growth across the S&P 500 is a great step for a more solid foundation for markets.

CRN: 2024-0802-11889 R

Opinions of this piece are that of Pence Capital Management and are not necessarily those of AAM.