May Investment Comments
The Economist, a British news magazine, put a cowboy on the cover of its April 15 issue and sang the praises of America’s resilient economy. They wrote, “America remains the world’s richest, most productive and most innovative big economy. By an impressive number of measures, it is leaving its peers ever further in the dust.”
Indeed, while Britain and much of continental Europe are experiencing recession, U.S. GDP expanded 2.6% in the fourth quarter, with the Federal Reserve Bank of Atlanta forecasting 2.5% growth for the recently-completed first quarter. After a volatile period during the pandemic, we appear to be regaining our old form of consistent real GDP growth above 2%. Although some forecasters are contemplating a late-year recession, almost no one expects a deep or long-lasting one.
Solid economic performance has given the Federal Reserve leeway to fight inflation with higher interest rates. With overnight rates now up to 4.75% and at least one more rate hike expected, the challenge is for economic growth to hang tough while higher interest rates go to work constraining prices.
The battle against inflation is still in its early to middle innings, but results look fair so far. Headline consumer inflation was 0.1% for March, below consensus estimates. Core inflation was in line at 0.4% for the month, up 5.6% over 12 months. Housing appears to be cooling off and may become outright deflationary, the direct result of higher interest rates. Energy’s contribution was more deflationary than expected. Inflation seems likely to moderate further as interest rates impact the economy with a lag and as consumers spend down the remainder of their excess savings from the pandemic. Whether the Federal Reserve can get inflation back down in the vicinity of 2% remains an open question, however.
Producer prices increased just 2.7% year over year in March, stoking optimism that cheaper production costs will flow through to consumer prices and reduce inflation even more. Volatile energy commodities affect producer prices more directly than they affect consumer prices, so energy’s surprisingly powerful downward force was likely exaggerated in producer prices. Energy costs have turned higher recently and seem likely to exert an upward force in future statistics.
March’s unemployment rate remained steady at 3.5%. Real wages increased 0.1% per hour but declined 0.1% accounting for a shorter average workweek. Labor force participation improved to 62.6%. This is welcome news after participation stagnated throughout 2022 at an average of about 62.2%. For most of the decade preceding the pandemic, participation fluctuated between 62.5% and 63.5%. By definition, increased participation brings more marginal workers into the measured economy. This is consistent with the trend toward shorter average workweeks, and it is one factor suppressing average earnings by diluting the average quality of jobs in the dataset. Rising economic participation is not inherently disinflationary, although its effect on average wages may appear so.
The banking sector regained some footing in late March and early April as shares of regional banks mostly stopped sliding. Stock prices reach equilibrium when buyers’ optimism precisely matches sellers’ pessimism. It is hard to find a balance while sellers are panicking, but eventually the panic runs its course. Now the optimists are noticing that small banks look cheap as long as enough capital remains available to ward off a shutdown by regulators.
Meanwhile, large national banks enjoyed a surge of deposits from customers fleeing middle market competitors. JPMorgan Chase reported record revenue in its first fiscal quarter, and management’s tone on the conference call was decidedly optimistic. The stock has already regained most of its March losses.
Disinflation, low unemployment, and rising workforce participation all fit the Federal Reserve’s ideal script, but there is reason for the Fed to stay frosty. Interest rate policy matches the economy’s present condition, but things can change fast, and there is risk in both directions. We hinted above at some reasons why inflation could be more stubborn than recent statistics imply. The Federal Reserve seems aware of these risks and has introduced strong language about inflation vigilance into its messaging. Meanwhile, what about risk in the other direction—the risk of overtightening? Interest rate policy works with a lag, and holding rates too high for too long could hypothetically cause unnecessary damage to both the financial system and the real economy.
In his 2022 letter to JPMorgan Chase shareholders dated April 4th, CEO Jamie Dimon argued that an inefficient and ever-expanding regulatory burden hinders banks’ ability to compete against more lightly-regulated “shadow banks” providing similar functions outside the banking industry. The result is that traditional banks play a declining role in the global financial system. Dimon’s implicit warning is that risk could be pooling in dark spaces where regulation cannot limit it. For example, institutional investors—sovereign wealth funds, pension funds, endowments, etc.—have for years been taking capital out of the public markets and the traditional banking sector in favor of private investments that are believed to offer higher returns with less downside risk. Critics often complain that private investments are quick to post gains when things are good but are slow to admit losses, creating a perception of high reward with low risk that only breaks down when markets turn down and stay down.
The recent banking concerns were driven by a combination of losses on bank assets, mostly because of higher interest rates, plus capital flight from depositors afraid of getting caught holding the bag when those losses came to light. The self-fulfilling nature of a bank run is well understood. Perhaps less well understood is that similar runs can happen outside the banking system whenever short-term lenders and investors start racing to claim a limited stock of liquidity.
The same shocks which recently whipped through the banking system may also be present in other corners of the financial system that are less transparent. A popular real estate investment trust recently limited the freedom to take redemptions. We have heard stories of cryptocurrency platforms limiting or refusing withdrawals. The turnstile lets you in but not out. Call it Hotel California risk.
We favor public markets. Although they are subject to investors’ whims, their quoted prices, however volatile, constitute a real offer to exchange securities for cash, or vice versa. Private valuations typically offer no such certainty. Investors may be fighting the last war when they worry about publicly traded banks, which are quite transparent to investors and even more transparent to regulators. The next financial crisis, whenever it comes someday, will look different. Pay especially close attention to weaker foreign economies for hints of where the risk is hiding. America’s economy may be top of the heap, but our exceptionalism only goes so far.
Miles Putnam, CFA