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Good morning and happy Monday! This week is a consequential one for the direction of the markets and may end up being a turning point into a sustained market downtrend. More on that below. Global markets are starting the week down on concerns that inflation is not contained. The Spanish CPI came in above consensus earlier today.
The economy gave up mixed signs last week. First, GDP, wages, and home prices remain stubbornly strong, though were are signs of weakening in several places that we will highlight below. But manufacturing data in particular seems to indicate that the US manufacturing sector (basically anything that isn’t strictly a service business) is now solidly in contraction territory.
We’re also seeing an uptick again in energy prices, particularly gasoline, which started this inflation spiral off in the first place back in early 2021. So we are cautious that inflation may in fact have bottomed for now and upward pressures may be mounting again.
At-a-Glance:
- U.S. Manufacturing recession now seems obvious
- What is the Beige Book and what is it telling us today?
- Leading indicators have never contracted this much without a recession
- An update on the jobs market
- Housing is in free-fall.
- What the heck is the Phillips Curve?
U.S. Manufacturing recession now seems obvious, and Services are weakening.
Additional data from the Empire State and Philly Manufacturing and Service Indexes for December were released last week. Both now show a significant contraction in production output and workers’ hours, indicating that our manufacturing sector’s slowdown is sustained, and widespread. The New York Service Index also reported a sharp contraction. It will be telling when we see the other regions’ reports later this month if it is fully nationwide, or just restricted to the northeast for now.
First, the Philly numbers:
Despite a slight uptick in new orders and output, both remain deeply in contraction. It is normal to see some “jagged” movements in these numbers, because an order placed on the last day of one month will be shown as output during the next.
Also, we are finally seeing indication that in the Philly manufacturing region, the expected number of employees is dropping. Again this is totally expected: if your factory’s orders slow, there will be a lot of standing around by employees staffed for full capacity. So, sadly, hours and even jobs must be cut to reflect the slower output.
Interestingly, the New York Fed released the Services Business Activity report last week, as well. This shows the continuing decline in the services sector (basically any work that does not create a physical product for a store shelf):
Larger companies can typically weather these economic storms better than small ones, so one of the indicators we would be looking for to see how the economy is affecting smaller businesses (roughly 80% of the companies in our economy) is factory/store closures. That report was also received last week:
The number of announced business closings jumped in December and January (and January was only reporting the first 22 days of the month).
Sales Managers around the country are surveyed as part of this data collection, and their responses are reported separately. It is generally assumed that company sales managers have the best actual understanding of current business conditions, even before CEOs and other executives might know. So sales manager reports are often considered leading indicators (advance notice of what is coming). Sales managers are reporting declines in nearly every area now, which should start to show up in company earnings reports, stock prices, and later economic activity reports:
What this means to you:
Recessions generally mean reduced economic output and are typically felt broadly across most parts of our economy. You can have output declines that are specific to one sector of the economy (housing, for instance) but a recession is declared when total output in the U.S. declines.
Reduced output sadly means that workers’ hours cannot be sustained at current levels. We would expect to now see a further reduction in the average weekly hours workers put in, followed by hiring freezes, then furloughs, and finally, if new orders for products remain low, layoffs and even business closures. We are now seeing all of these in parts of the country, and it is spreading.
What is the Beige Book, and what is it telling us today?
The Beige Book is a summary of economic activity that is gathered through surveys with all of the Federal Reserve Banks in the country, combined and then reported once every six weeks (eight times a year). There are twelve Federal Reserve Bank districts in the country, so the reporting of the consolidated data in the Beige Book gives us a look at the entire country at a glance.
Unlike regional reports like the Dallas, Philly, or Empire State reports we look at regularly, the Beige Book reports economic and financial activity for the entire country as a whole.
The current Beige Book reports show a significant slowing of economic activity throughout 2022, which continued into January:
You can see areas of confirmed recession in the shaded gray areas going back to the 1970s in this chart. We are not yet at the point of a national recession, but we are definitely close to it. Graphs like this are why there is disagreement among economists about whether we are in a recession now, or if one is imminent (we believe it is), and how deep and prolonged it may be. No one can know for sure.
Analysts love parsing the actual words of the Beige Book reports because they believe seeing the overall themes the Fed is talking about may give us insight into what actions the Fed may be taking next. Wall Street is begging for the Fed to stop raising interest rates, and the recent market rally is justified by market participants because they believe the Fed will have to lower rates sooner than they are now indicating.
However, the Fed’s task is to reduce inflation to a target rate of 2% per year. That means the place heavy emphasis on prices and wages in their decision-making. If there is still upward pressure on either wagers or prices, there is consequent pressure on the other. So the Fed must break both with their rate hikes and quantitative tightening (basically, make money harder and more expensive to borrow). The Beige Book in January most definitely shows that prices inflation in particular, seems to be concerning the Fed:
This coincides with our own analysis and previous warnings that inflationary pressures may not, in fact, be subsiding. We got a surprisingly high inflation indicator out of Spain just today, which again is confirming that we might have gotten a few months’ reprieve from high prices, but the rising cost of gasoline again here in the U.S. (along with significantly colder weather patterns recently) may push prices back up in the near-term as the government stopped draining our Strategic Oil Reserves. Remember that they must now replace all of that oil, effectively having to compete with consumers for oil in the coming months:
What this means to you:
The Beige Book shows a slowing economy, but not one that is in a recession yet. The fact that prices remain a strong concern, coupled with rising energy prices again, and a rip-roaring stock market over the last month, and that jobs are hanging in there for now (more on that below) are more signs to the Fed that inflationary pressures are not reined in yet. We think this will mean the Fed will announce this week another rate increase of somewhere between 25bps and 50bps, and likely tell investors that their work is not yet done. This may move the markets lower, which the Fed would honestly like to see in the short term. Wild optimism on the basis of a Fed rate pause (or even a pivot) that has not happened and likely will not happen for months, is giving investors false hope.
Leading indicators have never contracted this much without a recession.
A group of business and economic experts called the Conference Board meets regularly, to survey the economic output of the country, and to compile a large number of what are known as leading indicators (advance best-guesses), into their own report. The Conference Board’s six-month projections have never contracted as much as they are now, without a recession later being declared.
We can see that this Leading Index has continued to slide each month for most of 2022, and so far in 2023:
This is relevant because the actual GDP figures are lagging indicators in the extreme and are terrible predictors of how things are actually doing at this exact moment. The most recent GDP estimates only look at October, November, and December of 2022. The one we are all familiar with right now indicates conditions in July, August, and September of 2022:
What this means to you:
This report is one indication that the U.S. may in fact already be in recession, since recessions are based on negative GDP reports that are always LAG the economy by three months. But the leading indicators are showing activity six months from now, so our assumption here at nVest Advisors is that somewhere between now and mid-summer, the U.S. will finally be in a definite economic contraction.
A look at the jobs environment.
Jobs are a decidedly mixed bag right now in the United States. Some sectors of our economy are definitely shedding workers, like tech and finance right now. Yet other sectors showed strength in hiring in December:
Layoff announcements continue to climb, and manufacturing showed its first contraction in workers this month, so we expect to see the job market worsen in the coming months. But for now, the jobs data looks stagnant at worst, and the Federal Reserve will take that into account as they announce interest rate decisions this week.
What this means for you:
The job market IS slowing, but not very quickly. Layoff announcements are increasing, and we are seeing even business closures increase over the last two months. We expect to see a rapid acceleration of layoff announcements going into the summer months. If your job is at risk, it’s vital to have emergency savings built to offset any lost income until a new job can be obtained.
Housing is in free-fall.
One of the recurring themes of our economic analysis for months has been our conviction that the housing market will face a significant correction over the next few years. Record-high house prices due in large part to extremely inexpensive borrowing rates created a “bubble” in which even burned-out shells of homes in places like Denver were selling for $500,000. Obviously, to the consternation of your local realtor and mortgage broker, that kind of irrational nonsense was not sustainable.
Now that interest rates have more than doubled since last year (though there has been a slight and temporary drop in rates for the past six weeks or so), home sales have fallen off a cliff. We have said many times that the housing industry is the most sensitive to interest rate changes, so any major economic repercussions to the Fed’s current policies would be seen first in housing. For us, housing is a good leading indicator to see what’s coming for the rest of the economy.
New housing data last week shows the market for existing homes is in literal free-fall:
When you compare monthly sales lines to previous years (so you can observe seasonal changes in the market), it’s still terrible:
Inventories of homes are starting to climb:
This means home sellers are finally seeing a drop in the final asking price of the homes that do go on the market:
Not every seller is willing to take a price reduction on their property (yet), so this is starting to reduce the number of homes on the market in the first place:
What this means for you:
The next year or two will be a terrible time to sell a home. Motivated sellers, real estate investors dumping properties that have lost value or decide to get out of the vacation rental business as declines in bookings hit AirBnB and other short-term rentals due to a weakening economy (who vacations during a recession with high inflation?), and sadly, foreclosures due to coming job losses, all will combine to further weaken the prices of existing homes.
Don’t let your realtor lie to you: the next year or two will be a terrible time to sell your home.
However, for buyers, especially first-time buyers, get ready: this may be the best time in a generation to pick up your home at a much better market price. It will take a while for interest rates to come back down, so you’ll need to be able to afford a higher mortgage payment in the short-term, but once rates are back down, you can always refinance your home and save thousands. We actually watch the mortgage market for our clients and let you know when there are better rates and terms for your home loan, auto loan, student and personal loans, and more, and help you apply for and close on better loan options as they come.
What the heck is the Phillips Curve?
And finally, a macroeconomic lesson that gives us one more clue as to where our economy is headed. The Phillips Curve is a economic “rule” that says that inflation and unemployment have a stable but inverse (opposite) relationship with each other. Basically, whenever there is good economic growth in our economy, inflation is natural and should rise, and employment should go up with it. A Phillips Curve in every econ textbook looks something like this, courtesy of WallStreeMoJo:
When inflation is high, employment should follow. When inflation is low (or perhaps deflation is occurring), unemployment rises. The Phillips Curve indicates that high prices are good for company profits, which is good for workers.
Typically, the curve has extremes at each end, and occasionally a reading will stray from the line when the relationship between inflation and employment isn’t working correctly (like times of stagflation – high prices and slow economic activity).
The current Phillips Curve reached its absolute peak of this economic cycle, indicating that we have likely seen the very top of the economy for the near future. The curve will likely begin to swing down and to the right as GDP drops and unemployment rises.
This indicator, while not flawless, will show the Federal Reserve that the economy has reached is zenith for this cycle and that it is inevitable that it will begin the swing back the othe way. This may give the Federal Reserve room to “pause” after this week’s rate hike, to see how much the economy will move back along this curve on its own after the last year of Fed action. Remember that a pause in rate hikes does not mean the Fed is ultimately finished, nor is it the famed “pivot” Wall Street is clamoring for. It just means that, like a pendulum, we’ve reached the outer limits of the up-swing, and now gravity must do its part.
Bottom Line:
We firmly believe the United States and much of the rest of the developed world will endure a recession in 2023 and we re-affirm that this week. No one knows exactly when a recession will be declared, but we firmly believe most of the larger economies of the world are right at the door of one now. Recessions can take years to recover from, which is why we believe it is vitally important to get your family and business finances ready to weather through such a storm.
We do believe this week is consequential to the stock and bond markets. We believe the recent rally has fully run its course, and there will soon be a strong shift from stocks and into safer investment options such as corporate and government bonds. With interest rates this high, getting a 5% or better yield, risk-free, is no longer impossible. Once there is consensus that either the economy is now earnestly deteriorating, or the Fed announces the end of rate hikes, the move from stocks to bonds will accelerate.
Whether you are our client or not, you need to consider the broader economy (and much less so the daily market fluctuations) when making investment decisions. The economy is telling us clearly what is coming, and you need to have your investment accounts prepared before that happens.
Use these economic reports, and those of others working in this space, to prepare. You can not only avoid much of the pain that is coming, but you might actually profit from it, if your investments are properly positioned, and you’ve done what you can to shore up your business’ and family’s financial situation. If you need help with this, nVest Advisors has amazingly affordable personal financial planning and fiduciary investment management services to help you.
This is what we do for a living, and we’re very happy to partner with you on that endeavor.
Reach out to us for a totally free financial and portfolio checkup today if you’re concerned about where your finances sit for the coming few years, particularly if you are at or approaching retirement age. We’re delighted to offer you our thoughts. You can schedule that time with us below:
Watching This Week:
- Thursday, we will get updated news on the current inflation rate in the U.S.
- Friday, we will learn the new consumer sentiment numbers from the University of Michigan.
