Weekly Market Pulse: Things That Need To Happen

Perspective: per·​spec·​tive |  pər-ˈspek-tiv

b: the capacity to view things in their true relations or relative importance

Merriam-Webster

Perspective is something that comes with age I think. Certainly, as I’ve gotten older, my perspective on things has changed considerably. As we age, we tend to see things from a longer-term view.

Things that seemed so important at the time, years ago, turned out to be nothing more than bumps along the road of life. That is as true in my personal life as it is in my professional one but you don’t need to hear about the former so let’s focus on the latter.

I don’t view the economy through any preconceived lens. My natural state is not negative or positive but open-minded. I can’t predict how the billions of people who make up the global economy are going to behave. I can’t predict what governments will do that might impact the global economy (with some exceptions). I can’t predict the global variables that affect global trade and economic growth. For instance, I know of absolutely no one who can predict future exchange rates with any degree of accuracy. I can observe the present trend but predict where they will be six months from now? Millions of traders, hedge funds, economists of all stripes, some of the smartest people in the world have tried and failed. Yes, there are some who can point to specific instances where their views about some future economic policy proved correct and they were able to profit (Soros’s pound trade). But I don’t know of anyone who has a long-term track record that is much better than just plain luck. And most are worse. And exchange rates can have a dramatic impact on trade and a host of other factors affecting global growth.

If you have a preconceived notion about the economy (negative or positive), you will see all data through that lens. You will, in the lingo of psychology, be subject to confirmation bias. You will look for things that support your view of the world. And you will also frame things in a way that allows you to maintain your views. In other words, you will lose perspective.

The chart below shows the cost of shipping freight from Shanghai to Los Angeles. I have seen this or similar versions on Twitter over the last couple of weeks, always cast in a negative light. It purportedly shows a drop in demand in the US as the cost of shipping goods from China is falling rapidly. The price is down about 15% over the last year. This is confidently cited as proof of slowing demand in the US and more evidence that we are headed for recession.

Note: I’m not very good with graphics so this chart doesn’t show you the dates but the starting date for the graph is roughly mid to late 2021.

If you look at the entire set of data though, a different picture emerges. Yes, prices have come down but are still well above the pre-COVID level. In fact, the cost to ship from Shanghai to LA is still roughly 4 times the pre-COVID price. There could be a myriad of reasons why shipping costs have fallen recently but I have a hard time classifying this as bad news. One’s perspective certainly matters. If you are importing goods from Shanghai, this is undeniably, undoubtedly, good news. Your shipping costs just dropped by 15% year-over-year and if this downward trend continues, those costs seem likely to fall quite a bit further.

I don’t mean to imply that the US economy isn’t slowing as it obviously is. I think though that the slowing is something that had to happen, was inevitable in fact and isn’t necessarily a bad thing. My view, for quite some time, is that once the COVID distortions are over, the economy will return to its previous state of roughly 2% growth and 2% inflation. That is based on the simple observation that we did nothing during that time to improve the factors that affect economic growth (workforce and productivity growth). The debt we added at the federal level during COVID may turn out to be a negative but it may also be offset by positive balance sheet developments at the household and state government levels.

Budget Surpluses Push States’ Financial Reserves to All-Time Highs

After an early pandemic decline, states had collectively amassed their largest fiscal cushion on record by the start of the current budget year.

Higher-than-expected tax revenue—among other temporary factors—drove the total held in savings and leftover budget dollars to new highs. As states approach the close of fiscal year 2022, most expect to spend down at least a portion of their surplus funds.

The Pew Charitable Trusts, May 2022

U.S. household wealth drops for first time in 2 years

Household net worth edged down to $149.3 trillion from a record $149.8 trillion at the end of last year, the Fed’s quarterly snapshot of the national balance sheet showed.

The drop was driven by a $3 trillion fall in the value of corporate equities – a plunge that has worsened in the current quarter – while real estate values climbed another $1.7 trillion.

Still, the report showed household balance sheets overall remained healthy through the first three months of the year – some $32.5 trillion above pre-pandemic levels – and looked likely to continue to support strength in consumer spending in the face of high inflation.

Of particular note, bank account balances rose, with checkable deposits and currency rising about $210 billion to $4.47 trillion, and time and savings deposits up about $90 billion to $11.28 trillion.

Reuters, June 9, 2022

Even if we assume that the drop in shipping rates is a consequence of slowing demand, some perspective makes me think that this is a necessary and welcome development. The inflation we’ve experienced over the last year was driven, at least in part, by excess demand from fiscal stimulus (that was obviously unnecessary). Demand for goods – durable goods in particular – surged during COVID for many reasons. This excess demand for goods, coupled with constrained supply due to COVID restrictions, is part of the reason those shipping rates rose so dramatically.

Real sales of durable goods surged throughout COVID but accelerated rapidly with stimulus payments; sales peaked right as Biden’s American Rescue Act was implemented in the spring of last year. Sales have been falling since then, down 11.6% since the peak. That is obviously a negative for the economy since the peak but if the excess demand was responsible for some portion of the rise in prices – and it certainly was – then correcting the excess demand should have a positive impact on inflation. Isn’t that what we want?

While the goods economy is certainly slowing – and with good reason and potentially good effect in my opinion – the services side of the economy continues to recover from COVID. Services spending is approximately 1.6 times the size of the goods economy and 4 times the size of durable goods.

By the way, durable goods orders for May were released last week and were better than expected across the board. Core capital goods (which are durable goods) rose for the 11th month of the last 12.

The drop in goods demand is having a positive impact on inflation as well. We also received data on personal income and consumption last week which included the Fed’s preferred inflation gauge. The headline year-over-year change in the PCE price index was 6.3% the same as last month and down from the peak of 6.6% in March. The core PCE price index (what the Fed is watching) year-over-year change was 4.7%, down from 4.9% last month and the peak of 5.3% in February. We also saw a big drop in inflation expectations last week. The 10-year breakeven inflation rate fell to 2.34%, 5-year breakevens fell to 2.6% and 5-year, 5-year forwards fell to 2.08%. The track record of inflation expectations as a predictor of future inflation is pretty poor but it does show that investors’ fears of inflation are fading fast and I think for good reason.

But assuming that the outcome is some kind of 2008-style financial crisis is just assuming way too much knowledge about the future for me. A little perspective can provide much-needed clarity about the present state of the economy.

The rising rate, rising dollar environment has changed but only slightly. The 10-year Treasury yield is down over the last month. That is not sufficient for us to make big changes to our portfolios but a small change may be warranted. The yield did break a short-term uptrend last week and it seems likely that rates will continue to pull back to the targets I mentioned in the mid-year update. Confirmation of this trend is found in the copper/gold ratio which tracks the 10-year yield pretty closely:

We are likely to extend the duration of our bond portfolio again soon, an acknowledgment of slightly weaker economic conditions.

Stocks were down again last week but the bond rally helped balanced accounts for a change. A 60/40 portfolio of Vanguard Total Stock market and Vanguard Total Bond market was down about 1.4% last week or, as you might guess, about 60% of the drop in stocks. Our moderate portfolios were about flat last week, some down a fraction of 1% and some up a fraction. More conservative accounts were up on the week as our recent extension of duration paid off. If we are indeed moving toward recession of some kind, we will likely continue to extend duration. I don’t think, right now, that we will expand our bond allocation beyond the strategic mandate but it is still possible depending on how the economy develops.

My biggest concern right now continues to be credit spreads which widened slightly last week.

There seems to be a rush to buy the dip in the energy sector but I’d be patient. I think crude has more downside with a target in the mid to high 80s.

Right now, futures market continues to point to the first half of next year as the peak in rates around 3.3% on Fed Funds. That changes by the day as new information is incorporated into the market.

A couple of months ago, the peak wasn’t expected until sometime around the beginning of Q4 2023.

Note: By the way, I am using SOFR futures rather than Eurodollar futures now since open interest in Eurodollar contracts is fading.