- General Mills lifts outlook after earnings
- Adobe gives conservative guidance
- New home sales decline
After last week’s Federal Reserve meeting, this week’s economic reports are not as momentous. Nevertheless, they provide important clues to what is happening in the markets. Today, initial claims for state unemployment fell to the lowest level since 1969. In the week ended March 19, the Labor Department said claims fell 28,000 to 187,000. The median estimate in a survey of Bloomberg economists called for a level of 210,000. Continuing claims for benefits fell to 1.35 million in the week ended March 12, the lowest level since 1970. The interpretation of these figures is that employers are reluctant to terminate workers as the available pool of labor remains low with a participation rate of 62.3% compared to 63.4% at the end of February 2020. The strong monthly nonfarm payrolls figure over 670,000 released on March 4 showed that households are looking at dwindling savings and decades-high inflation as incentives to seek new employment. The last time initial claims were this low, the unemployment rate was 3.4%. That is not too far from today’s 3.8% rate.
In other economic news, new home sales fell in February for a second month. According to the Census Bureau and Department of Housing and Urban Development, single-family home sales fell 2% to a 772,000 annualized pace following a downwardly revised 788,000 in January. The median estimate in a Bloomberg survey called for a 810,000 annualized sale rate. Buyers are hampered by high home prices and rising mortgage rates. The median sales price jumped 10.7% last month from a year earlier to $400,600. Inventory is becoming less of a problem as there were 407,000 new homes for sale as of the end of February, the most since August 2008, though about 91% were under construction or not yet started. Freddie Mac said that the average 30-year mortgage loan was 4.42%, up from 4.16% last week and the highest since 2019. At the beginning of the year, the monthly payment on a $300,000 loan at the 30-year average at the time (3.11%) would have been $1,301. Now, that monthly expense has risen to $1,506.
The Fed Strategy for Inflation
The question the Fed has to wrestle with is will the rise in yields lead to demand destruction. There was about $5 trillion in fiscal stimulus provided between March 2020 and spring of last year providing plenty of ammunition to households to spend on foodstuffs, rent, Pelotons and other goods as they carefully navigated the pandemic as it spread, waned, surged with new variants and subdued by vaccines and acquired natural immunity. With that spending now in the rearview mirror, the economy is getting back on its feet on its own. However, consumers are now facing inflation that has not been seen since the 1970s in some categories, stretching paychecks unlike in recent memory. The Fed has two mandates: full employment and stable prices. The labor market is strong but there remains confounding gaps in the labor pool. Many older Americans retired much sooner than expected, yet there has not been an associated spike in the number of filers for Social Security. Prime working age participation was expected to bounce back in the fall with widespread vaccines available yet the Omicron variant spike has further delayed the “return to normal.” Recent comments from Fed Chair Jerome Powell hinted that a 50 basis point hike (0.50%) could be enacted at future meetings, the next of which will occur in May.
The market is getting increasingly nervous that the economy will lose its forward momentum and a recession will occur. We are tracking a number of indicators. The slope of the yield curve has historically been an indicator of slowdowns. If the yield on shorter-term maturities exceed those of longer terms (a so-called inverted curve), that suggests traders are anticipating the Fed to cut short-term rates in the future. We have not seen this happen yet but the spreads between maturities are getting smaller. Another metric of importance is the Conference Board’s Leading Economic Index (LEI). It has correctly predicted every recession since 1970 by turning negative before the economy faltered. It tracks 10 subcomponents ranging from building permits to unemployment claims to new orders of nondefense capital goods. If enough of these factors turn negative concurrently, it is a sign the economy is not well. While the LEI is not at its most recent peak reached in April 2021 and its most recent reading in February was its third consecutive decline, it is still far enough away from zero to not signal a new phase of the cycle. We also monitor the spread between high yield securities and “no risk” Treasuries. The rationale is that if companies are about to enter a downturn, the riskier borrowers will have a harder time paying obligations and borrowers will demand a higher return compared to yields on U.S. government paper. The Barclays Capital US Corporate High Yield yield-to-worst minus the U.S. generic government 10-year yield has risen from a 2.7% spread at year-end 2021 to a 3.8% spread now with a 2022 peak of 4.3% just a week ago. While higher than three months ago, it is now just back to the level seen in late 2020 right before news of the vaccine breakthrough was released and far from highs of 10.9 reached on March 23, 2020 at the start of the pandemic and 20.6 attained in December 2008 during the heart of the financial crisis. Oil prices have also been causes of recessions in the past. Since 1970, a rise in crude oil costs above 50% has either proceeded recessions or exacerbated recessionary conditions. We had that spike and then some when the price of a barrel of Brent crude (the worldwide benchmark) jumped from the high $30s in spring 2020 to close to $140 with the beginning of hostilities in Ukraine in early March. Though geopolitical events are notoriously difficult to handicap, the likelihood for prices to have that type of rise over the next two years is highly unlikely, thus, much of the pain has already been felt. Additionally, none of the spikes over the past 40 years included a worldwide pandemic which deflated global demand for two years creating a potentially artificially low level of prices. Admittedly, the longer prices remain elevated, the more damage is done globally since it serves as a tax on consumer demand.
Recessions are part of the business cycle that are inevitable but never welcome. While indicators are flashing yellow right now, there is no guarantee that a recession is in the cards. It will be determined by the interaction between Fed moves, employment gains, geopolitical events and supply chain improvements. We will continue to monitor the environment and make appropriate decisions based upon our outlook. Heightened volatility in the equity markets is likely to continue as investors discount relevant news and trends. Our diversified, balanced portfolios are well situated to deal with these uncertain times. As we wrote in the quarterly commentary, this year is about adjusting expectations to the reality of the investment environment. Being disciplined and patient is the key to positioning holdings for long-term growth.
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