A Note from Jeremy, CEO/CIO: Economic News

Happy Monday! The markets are starting to settle in to the reality of both a declining economy, increasing unemployment, and inflation that appears to be reversing and heading in the wrong direction. This paints the Federal Reserve Bank into a tight corner. The Fed is tasked with two mandates: maintain price stability (inflation) and stable employment. Their actions since early 2022 (collectively known as Quantitative Tightening) have been to lower inflation back to the Fed’s target of 2% per year, without causing a recession and sending unemployment higher.

The problem is, this has never been accomplished before.

I think today’s preamble should discuss the causes and impacts of inflation, since that is what seriously concerned Wall Street last week (though, as our readers will recognize, we’ve been expecting inflation to remain sticky and stubborn for many months).

First, what is inflation?

Inflation is mistakenly believed by many to mean rapid price increases on the goods and services we consume. These price changes are the result of inflation, not inflation itself.

Inflation is a rapid swelling of the supply of money in an economy. This can happen organically, as the economy runs “too hot” for a long period of time, or it can happen as a result of excessive money creation due to other circumstances, such as government spending during wartime.

If your wages keep up with inflation, you won’t notice a change in your quality of life, but historically, wages can’t keep up with prices. Prices can rise every day – how often are you given a pay raise? And if you’re feeling like life really is getting more expensive, that’s not “in your head”, as many of our politicians are trying to gaslight you right now.  Our wages have always bought less and less, and it gets much worse after each recession:
When inflation happens naturally, it’s usually after a long period of solid economic growth in an economy, which has emboldened companies and individuals to take on more debt. A company feeling optimistic may borrow to expand their factory operations and hire more workers, buy the corporate jet, and lavish their managers and employees with pay raises. Individuals who are optimistic about their job security and earning prospects may start to borrow to increase their standard of living – a new luxury car, a bigger home, etc.

These loans, to both businesses and individuals, typically come from banks. Because of our nation’s fractional reserve system, most of the money in these loans does not come from the bank’s depositors, as you might think (a bank accepts your savings deposit and then lends it out). Banks are allowed to lend out many times more than the money they have on deposit, and this money did not exist before the bank made your loan.

This is the source of most of the inflation in modern economies. A bank with, say, $10 million of their customer’s deposits on account might be allowed to lend up tp $150 million – or more – of money the bank does not have. Your deposit money is part of the loans the bank makes, but they are required to keep only a fraction of those deposits on hand for withdrawal requests (called the bank’s “reserve requirement”). The rest they can lend out, along with a multiple of those deposits that do not physically exist. This is why the banking system in most of the developed world is known as a “fractional reserve system”, and inflation is a natural part of the process because our banks invent money each time they underwrite a new loan.

Normally, it doesn’t get out of hand because borrowers pay back the loan, plus interest (which the bank keeps as profit), so most of the “invented” money is only temporary.

This simplified example is the first way inflation can occur. The second is when the governments of the world spend more than they take in from taxes. In this case, the government acts very much like a company or a consumer – they must borrow the extra they want to spend. This is called deficit spending. Getting the extra money can be done in two ways; both of which cause inflation.

First, a government can simply print more dollars at the treasury. This immediately and directly causes inflation because new money just “shows up” in the economy. The other, slower method is for the government to borrow money by issuing IOUs (we call them Treasury bills, notes or bonds, depending on how long the government is going to borrow it). The government pays interest just like a business or individual, and when the IOU comes due (“matures”), the bond owner gets their money back.

Individuals and companies, and even foreign governments can buy government bonds, but so can our Federal Reserve Bank, and a lot of our government debt is carried by the Fed, which just like a smaller community bank, simply invents the money out of thin air to purchase the government’s IOUs. The process of creating money in order to purchase government debt is called Quantitative Easing.

Inflation, then, is the increase in the amount of money in circulation. It can be kept under control if we are, at the same time, producing more goods and services for the new money to be spent on, but when there is a dramatic shift in the availability of products or services compared to the money out there to purchase them, the price of those items will go up, sometimes very rapdidly. So inflation can happen both when there are too few items to buy, or when there is too much money circulating. They are different in cause and solution.

Let’s imagine that this year, a series of early spring freezes extended so far south that it wiped out much of this year’s coffee crops in central and south America. There would suddenly be much less coffee available on the market, but the dollars out there wanting to buy some. This is inflation created by a supply disruption, and as soon as that lack of supply is corrected, prices will typically return to normal.

The other problem is much more serious. When there has simply been too much lending and deficit spending, the supply of dollars is too high for all products and services, and so prices rise on everything at once. There are only so many cars, houses, heads of lettuce, and gallons of gasoline out there at any given time. If you have the same number of items for sale as the year before, but suddenly trillions more dollars out there to purchase them, prices will go up on everything simply because the value of each dollar is much less than before the surplus cash arrived.

This situation is what the governments of the world subjected us to during the Covid-19 pandemic. During that time (and most analysts and even political leaders now agree this policy was a colossal mistake), the economies of the world were shut down. You could not go to work or school, ships with cargo stopped being loaded and unloaded, and life basically ground to a halt.

To keep the economy alive during this shutdown the governments of the world tried to stimulate their economies with lots of money, printed literally out of thin air. Here in the United States, those came in the form of stimulus checks and forgivable Paycheck Protection Program (“PPP”) loans to businesses, to keep making payrolls until the company could resume its operations.

The total spent in the United States in the wake of the Covid-19 shutdowns, in pure deficit spending, was greater than $6 Trillion. This money was created out of thin air and dropped – often unproductively – into the economy. And because we had so many supply disruptions, prices on nearly everything jumped immediately.

Our Fed at first believed that as supply problems subsided, so would prices. We did not believe this was true. We believe that widespread inflation, in all parts of the economy, all at once, is first and always a problem with too much money. We knew that the Fed would have to start taking drastic action to lower inflation, but we also know from history that inflation tends to come in waves, and if banks, thinking they’ve got inflation beaten, stop tightening the money supply too quickly, inflation often comes roaring right back:

The recent 3-month rally in the stock market (let’s set aside the fact that the rally was not the broader economy, but just a few tech stocks) was because Wall Street believed that the Federal Reserve had done enough to conquer inflation and that interest rates would be coming down for nearly all of 2024 (making borrowing cheap again). In a far-t00-premature celebration, stocks rallied way up on the (false) hope of lower rates, cheaper borrowing, and economic stimulus.

However, last week gave us solid confirmation that inflationary pressure had resumed (exactly as history shows and that we predicted it would).

The return to reality has started, and this will, sadly, mean that all of the recent rallies – and likely, even more – must be unwound.

Add to that the fact that our economic analysis shows we are on the razor’s edge of a recession (as we’ve shown for well over a year), which naturally follows periods of quantitative tightening and marks the end of a perfectly normal business cycle. When we get rising prices and a slowing economy, we get what is known in economics as “stagflation”, and it can be a frustrating and economically challenging time for families and businesses.

We are not here to “doom and gloom,” just to provide our clients and prospective clients with the economic reality. For our clients who grant us discretionary trading authority, we are adjusting your investing strategy to accommodate this analysis and protect your assets from the worst aspects of this coming downturn. This blog serves as one part of our transparency commitment to our clients to give you a look “behind the curtains” of the investing decisions we make, and why we make them.

Later this week, we will lay out our case for why we believe a recession is now imminent or has already started. Stay tuned for this special report.

~ Jeremy, CEO

  • Jobs Update
  • Real Estate Update
  • Housing Update

Jobs Update

We did a deep dive into the jobs market in our last update, so today we’ll just show you the most recent numbers. Needless to day, we strongly believe unemployment will soon become a concern in the economy, and that will serve not as a predictor of an impending recession, but that we’re already well into one.

Initial unemployment filings are still near historical lows and started off the year a little better than 2023, but we have several points to make that this is misleadingly optimistic:

The first is that the government survey data is increasingly disconnected from household surveys. In other words, when you ask actual WORKERS instead of government computer models, the employment situation is completely different. According to government models, 355,000 jobs were created in January, but when you ask families, 200,000 reported losing their jobs. This is greater than a half-million job discrepancy, just in a single month.

Next is the continuing claims for unemployment benefits. 2024 continues the trend of last year, in that it is still relatively easy, but slowing getting harder, to find a new job if you lose your current one:

We believe this trend will worsen, as surveys of small business (where about 75% of our jobs come from) show a continuing trend to slow their hiring, as business optimism erodes:

And it is not just that companies will stop hiring (which is the first step). Layoffs are typical as recessions are underway. Mentions in company earnings calls of “operational efficiency” (this always means cutting staff and lowering payroll expenses) are spiking:


This is in addition to the number of WARN notices (60-day required advance notices of layoffs for companies with more than 100 employees). So while we currently have a low initial claims rate, we have a substantially higher number of companies who have now given advance warning of layoffs coming (over 300,000 next month):

And a strong jobs market is more a matter of where you live, than a wide, robust economy throughout the United States. More than 60% of the country’s metro areas are now showing rising unemployment:

Once again, tech companies are leading with the layoff announcements, which is one reason that we believe the recent rally in tech company stocks was far too optimistic and premature:

However, unlike last year in which nearly all of the layoffs were in the tech sector, 2024 layoff announcements are far more widespread, with financial companies and manufacturers outpacing tech so far this year.

One area we expect to see more job losses is in construction. The housing market (see below) is now in freefall, and we can see now that the gap between construction employment (very high) and construction activity (low and dropping quickly) has never been greater. There will, sadly, be many more layoffs coming in the real estate and construction sector in the coming weeks.

What this means for you

We continue to watch employment for a number of reasons. First, and most obviously, employment tends to give you an inside look at the overall financial health of a company, industry, and economy. But also, when unemployment spikes (and it does indeed spike it doesn’t usually just creep up, as the chart above demonstrates), it can happen very quickly. That loss of income will immediately impact spending and credit payments, which is where the recessionary pain really comes from.

Employment is a lagging indicator. It is not logical to watch for unemployment to change before you alter your investment risk profile ahead of economic challenges. We believe we have already positioned our clients properly for what Wall Street will always claim is a “surprise” or “unexpected” spike in unemployment, because we have no reason to believe this business cycle will be substantially different than prior ones.

Real Estate Update

After a brief attempt at a rally as mortgage interest rates dipped in the past few months, the real estate industry is in freefall. The headlines last week were bleak as the markets were caught off-guard by the drop in housing activity (our readers, however, were not – we’ve been expecting this since the summer of 2022):

 

First, new construction updates. Housing starts, as the headline above alerts us, dropped massively:

After a long run of new apartment construction keeping the industry afloat, that sector has slowed down even worse than single-family housing:

This is due to mortgage rates increasing and bank lending standards tightening again as inflation starts to make a second wave (as we discussed above) and the recession finally arrives.

Mortgage demand dropped back down after a brief respite in November and December:

The good news in all of this is that, as the economy worsens and sadly, some homes will be lost to foreclosure (and Real Estate investors walk away from unprofitable AirBnB-style ventures), home prices are finally declining (and will continue to do so):

But it won’t be easy for those working as realtors or mortgage brokers. Currently, real estate agents have fewer transactions per year than at any time in recent history, even worse than during the Great Financial and Subprime Mortgage Crisis of 2007-2011:

 

We believe the biggest concern in real estate right now is not residential (but that will come later in this recessionary cycle), but rather, COMMERCIAL real estate, which has struggled ever since “work from home” became common during the Covid-19 pandemic. As office space vacates, landlords are faced with more than $2 Trillion of mortgages on commercial property that are due to be refinanced this year…

…and with interest rates remaining much higher than many real estate investors believed they would be, we think a cascade of defaults and bankruptcies in the commercial real estate market will be the first of two major credit events in this recessionary cycle.

Most commercial property lending is actually handled by regional and local banks, not by larger international banks. Almost none of the commercial real estate loans are protected by government-backed insurance:

What this means for you

We believe there will be continued pain in the mortgage and real estate sectors, particularly in commercial real estate investments where office space is a high percentage of the assets. A large number of people who bought homes in 2021, 2022 and 2023 did so in the hope of a quick refinance to a lower rate as soon as the Fed pivoted. However, with inflation running well above the target, and inflationary pressures resuming, this may not happen very quickly. Additionally, a large number of investors in homes for short-term rentals (think AirBnB) are starting to struggle with fewer and fewer bookings, and cities and counties starting to restrict or even ban these kinds of uses of residential property. We believe a large number of the homes currently listed on AirBnB may, in fact, return to the market as they prove to be harder and harder to achieve profits.

If you are in the market to buy a home, we urge patience – we believe that both house prices and interest rates will decline in the coming months.

Bottom Line:

Download our brand-new E-Book “7 Hacks To Recession-Proof Your Financial Life” today.

We’ve been alerting our clients for nearly two years now that inflation was going to cause significant problems and our central banks would have to take progressively stronger actions to combat it. No one knows exactly when a recession will be declared, but we 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 predicted the beginning of a turn in the current market rally last week, and we reiterate that sentiment now. There will always be market movements that run counter to the economic data because markets are much more short-term focused, and let’s face it: until fear takes hold, greed is the prevailing emotional state of most of Wall Street. We do believe, however, that the recent rally has fully run its course, and the shift from stocks into safer investment options such as gold, cash, and government bonds will continue. With interest rates this high, getting a 5% or better yield, risk-free is becoming a more and more attractive option for investors concerned about the coming economic uncertainty. Once there is consensus that either the economy is 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.

Almost a year ago, I published an ebook to help you get your finances ready for the recession directly ahead. It’s yours totally free. Just click on the book image to access and download it.

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:

Schedule a Free Q&A Call with Jeremy Now

Our Economic nSight articles are typically written once weekly by nVest Advisors CEO Jeremy Torgerson for the general education of the public, and as a way to provide transparency for our clients and sponsored-plan participants as to how we create and modify our investment models. It is copyrighted and may not be republished in whole or in part without written permission.

At nVest Advisors, we believe that successful investing depends on an understanding of, and correct response to, changes in the world economy as they happen. We incorporate real-world economic conditions into almost all of our investment models and strategies at nVest Advisors, which we believe provides significant benefit to our clients’ overall investment returns by reducing various short-term market risks and enhancing portfolio performance over time.

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