May’s disappointing inflation data was the catalyst for a more aggressive Fed response, but there are concerns that it is too much for markets to handle.
Positioning for a period of uncertainty and a potential recession is always challenging, but in a world still grappling with the Covid-19 pandemic, it could look a little different this time around.
The U.S. housing market has been red hot for two years. However, as mortgage rates rise, a new equilibrium will likely need to be established – and it could have negative implications for growth.
The lead-up to the recent interest rate hike
With little to focus on during the month of June outside of economic data and the Fed, it is no surprise that volatility has surged once again. First, U.S. CPI for the month of May came in hotter than expected, sparking fears that the U.S. economy may slow more quickly than anticipated due to the impact of higher prices and higher interest rates.
On a year-over-year basis, prices rose by +8.6%, more than expected to the highest level in more than 40 years, and on a month-over-month basis, prices were up +1.0%, well above the monthly pace of +0.3% in April. More concerning was the reversal of positive trends exhibited in the April report, namely an increase in energy prices, along with used car, shelter and airline costs which all ticked meaningfully higher in May. For its part, U.S. PPI for the month of May rose +10.8% year-over-year, and +0.8% month-over-month, led once again by higher energy costs. While this is down from the +11.5% increase in March, PPI is still running at an elevated level, which points to continued pressure on CPI as companies look to pass through these costs to consumers.
These developments prompted an almost immediate reset in interest rate expectations and the Fed responded strongly to the deteriorating data, increasing interest rates by 75 basis points in its June meeting and releasing a revised dot plot, shown below, which points to a much higher fed funds rate by the end of the year than the rate previously communicated in March. What was lacking in terms of the Fed’s messaging were any additional details pertaining to quantitative tightening, which describes the process by which the Fed will over time begin to decrease its balance sheet. The effects of this process are as-yet unknown, given that the Fed has continuously been adding to its balance sheet in the post-GFC era, and therefore the magnitude of the impact on bond yields when coupled with interest rate hikes could result in even tighter financial conditions than currently expected.
With that said, it is important to acknowledge that recession risks are rising primarily due to higher energy costs and the potential for slower consumer spending based on declining levels of discretionary income as a result of higher prices. Consumer sentiment has been hampered by the perception that there is little the government can do to provide energy price relief, and while there has been some evidence of lower goods spending, particularly by lower income households, services spending has not reflected these pressures just yet.
In addition, there is growing concern that the Fed will be unable to deliver a soft landing and that aggressive monetary tightening will result in a deep, sustained recession is, in our view, an overly negative assessment of the current economic situation. Leading economic indicators have slowed; however, they are still positive, with PMIs remaining about the 50 mark and reflecting positive new orders activity. Job openings continue to vastly outpace job seekers, and while we acknowledge that all of those job openings are unlikely to be filled, any meaningful uptrend in the unemployment rate and ripple effects from a softer labor market will be reflected first in a decline in openings.
The likelihood that we are already in a recession is in our opinion low; however, that risk does increase as we move into 2023. We do acknowledge that the equity and bond markets are already reflecting perhaps not a deep and sustained recession but are clearly reflecting the threat of significantly slower economic growth – and typically, these declines occur ahead of a recession, should that scenario materialize in 2023.
The investor's delicate balancing act
With recession risks rising, it is important to consider how portfolio assets might react to such a scenario. The assessment and assignment of risk to different sectors, industries and companies in this environment is nuanced based on the underlying businesses. While cyclicals (energy, materials, industrials and financials) typically weaken in a recessionary environment, the overhang of the pandemic and continued disruption of supply chains particularly in China may offset the typical decline in cyclical demand that comes with a recession. The result may be a more shallow recession given the pent-up demand that has not been met since late 2020.
In addition, there may be an acceleration in the pace of the shift by companies to move production and distribution closer together, in an attempt to mitigate the fragility of the current system of global transport. For example, growth industries such as software could face some near to mid term pressures, although there is little evidence that enterprise spending is declining. In fact, one could argue that the need for productivity enhancing technology will become even more critical as production ramps up onshore amidst a lack of skilled labor in many industries in the U.S. and Europe. However, a refocus by private and public companies on disciplined capital allocation and hiring in order to minimize cash burn and shorten the time to profitability will be critical for companies operating in innovative and/or disruptive industries to gain investor confidence, particularly as multiples for many sectors are still higher when compared with broader indexes.
The low interest rate/low growth environment leading up to 2020 created a sharp divergence between technology stocks and the rest of the broader industry, given these companies’ ability to engineer their own top and bottom line growth and initiate massive share buybacks financed at historically low interest rates.
Our view is that the global economy is going to be in a higher interest rate/higher inflation environment for the foreseeable future; however, there will be a ceiling on rates as investors right size their allocation to risk assets, adding back fixed income over the next year, moving up in credit quality, decreasing their allocations to shorter term speculative instruments and focusing on a balance between cash in hand and capital appreciation as dividend and bond yields are likely to outpace inflation by the end of next year.
Cash flow and balance sheets will be increasingly important. Focusing on companies that can thrive in a slower growth environment is also warranted – which would continue to point to longer term opportunities for innovative companies to succeed.
Will the housing market peak in 2022?
As investors consider the ramifications of slowing consumer demand, one area of the economy which has already adjusted to higher rates is the housing market. Existing home sales continue to trend lower as high prices caused by limited supply couple with increased mortgage rates to suppress activity levels. April existing home sales fell by -2.4% month-over-month and -5.9% year-over-year to 5.61 million units, which is still above 2019 levels but is the lowest level of sales since mid-2020. While sales have declined, prices continue to rise, with the median home price up +14.8% year-over-year to $391,200 – the highest on record. The median is skewing higher as sales of homes between $100k and $250k fell by almost -29%, while those priced between $500k and $750k rose by +19%.
Speaking to affordability pressures, homes are selling quickly, due in part to sales to investors, who made up 17% of purchases in April and all-cash sales which accounted for 25% of all sales. Supply remains historically tight, albeit slightly improved from March; inventory at the end of April was 1.03 million homes, down -10.4% from a year ago, and representing 2.2 months of sales at the current pace.
It is this supply squeeze that represents the biggest challenge for housing in terms of overall economic impact. Residential investment factors directly into GDP, but also creates significant housing adjacent spending in the economy. With more people choosing to stay in their homes, anchored in some capacity to low mortgage rates, prices could remain high at least through the summer months, before stabilizing and in some markets even perhaps experiencing modest declines into 2023.
The longer term implications are that the U.S. needs more housing that is affordable and accessible, but developers and builders are likely to become increasingly more conservative if housing data continues to trend as outlined above.
We encourage you to reach out to your Private Wealth Advisor for a deeper discussion on the points above, or a review of your current plan to ensure it remains aligned with your long term needs and goals.