Our economic updates are 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.
For more information about our investment philosophies and management style, click here. To receive these economic updates and other company news via email when they are published, always free of charge, please subscribe here.
Good morning and happy Monday! This past week, we got new inflation data (the CPI and the PPI), as well as a good look at bank lending and specifically, commercial real estate troubles. Check out my daily economy journal that you can read and subscribe to at “Think Like A Rich Guy”):
- CPI and PPI Update
- Jobs Update
- It’s getting harder to get a loan
- Commercial Real Estate is in trouble
CPI and PPI Update
Last week, we got updates to both the Consumer Price Index (CPI) and Producer Price Index (PPI). These are the look of prices for both the makers of goods and services (PPI) and the end-buyer of those good and services (CPI). PPI tends to lead CPI by several months, though it’s not a perfect correlation for several reasons. This is because producers are hesitant to raise prices in response to their own cost increases (because higher prices will make you less competitive, at least initially). And then, after consumers are used to higher prices, producers tend to leave their prices elevated for as long as possible (until their competitors start dropping theirs), to maximize profit margins.
So here’s what we see for the CPI and PPI reads for the first quarter of 2023. Let’s start with producers. PPI came down dramatically and continues that trend, giving me hope that inflation is truly headed down in a meaningful way (though there are definite headwinds – energy prices resuming their upward trend is a significant concern):
This was a surprise drop for most economists, largely driven by the drops in energy costs. However, when we strip out incidental purchases and focus more closely on the core goods and services companies regularly spend capital on, we saw the same kind of surprise drop in prices, this time, seeing the first decline in prices for producers in over two years (top chart). The trend on producer prices is definitely lower year-over-year (second chart).
Now if we dig a little deeper into both the topline and core figures, we can see exactly what prices are trending up and down for companies right now. Headline PPI contributors show that really only two major production cost factors declined (service providers that companies use like health care, accounting, insurance, tax prep, etc.), and Energy. All other factors were basically flat.
We’ve talked several times about the upswing in energy price pressure over the last few weeks, so it remains to be seen whether this trend will continue.
The PPI indicates that prices are indeed cooling for manufacturers and service companies, which is a good thing as demand softens and much of the world teeters on a recession. And even with the lag effect that PPI has on the final purchase price for consumers, we got a slightly positive surprise on CPI for March, as well, as it came in 10 basis points below expectations:
However, that drop for consumers is also almost entirely energy prices. Stripping that away and looking at what we spend money on each month instead, we see the Core CPI is still very elevated (though slightly lower than in recent months, to be sure).
And breaking out the physical goods we buy so we can just look at the services we pay for (internet, phone, subscriptions, deliver fees, etc.), we can see some relief but still very elevated month-to-month:
Again, we can break down the larger number and see which parts of our budget are getting more affordable, and which remain elevated. The only factor that dropped inflation for us last month was energy. All others were elevated or flat.
What this means to you
It appears that inflation, in general, is off of its peak, but we remain cautious that inflationary pressures may resume, particularly with the recent oil production cuts from OPEC. While we are cautiously optimistic that inflationary factors are cooling off, the persistent demand for more workers means that even if the prices of commodities like energy, lumber, iron and other production costs drop due to the slowing economy, the strong demand for workers will add significant costs to companies that they will push down to the purchasers of their final product or service. Combining rising energy and labor costs means, in our view, that inflation may not be as well-tamed as it appears at the moment. Time will tell, but we remain cautious that inflation is going to be stubborn and persistent, requiring more action by the Federal Reserve than the investment markets have factored in just yet.
In fact, we can see this clearly in a recent Fed “dot plot” graph, in which the voting members of the Federal Reserve Open Market Committee (FOMC) vote on where they believe interest rates will be in the coming quarters. Each “dot” is a survey opinion (not a binding vote – they vote at each meeting, not in advance) of a member of the Fed, with the red line indicating the mean of the Fed’s members’ estimate:
The blue line, way below the Fed dots, is where the MARKET believes interest rates will be. So the question is, do we second-guess the Fed, or go with their guidance? Wall Street is betting that the Fed will “pivot” and lower rates sooner than the Fed themselves are expecting, and has therefore rallied on the basis that the Fed lacks the willpower to keep rates higher for longer. In effect, Wall Street is playing a game of “chicken” with the Fed at the moment. We think that’s silly. Our firm is taking the Fed at its word and is investing accordingly.
Jobs Update
As we mentioned above, one of the primary factors keeping prices elevated is the strong demand for workers ever since the Covid-19 pandemic. There are presently 1.6 jobs available for every job seeker, so the pressure is still on companies to compete for those workers. This causes an elevation in wages, which in turn, causes an elevation in the final prices of the products and services those companies make. This “dance” between wage pressure and price pressure is what the Federal Reserve is now trying to eliminate, and the only way to do it is to slow the economy enough to kill the need for those extra workers. That’s called a recession.
We get weekly jobs data, and while there wasn’t a major change last week from the week before, some more nuanced data gives us even better insight, so I thought we’d look at those data points today.
First, initial jobless claims remain above the average of the last few years (excluding the wild ride of 2020 and the unnaturally strong return to work in 2021), and are higher than the average of the last few (sane) years for the seventh week in a row. This tells us that layoffs are definitely happening now, and started months ago but there was a delay in those layoffs showing up in unemployment claims due to severance packages, especially in the tech sector:
But here’s where it gets interesting. CONTINUING jobless claims have spiked dramatically in the last few weeks. This tells us that yes, companies are laying people off right now, but unlike a month or two ago, those laid-off workers are having a MUCH harder time finding a new job. As you can see, excluding the insanity around the Covid-19 economic shut-downs, the last time we had continuing jobless claims this high was back in 2009:
And looking back even further, we can see that any time continuing jobless claims were this “sticky” (again, ignoring the nonsense that happened in 2020), we had a recession.
This is happening despite the fact that our labor participation rate remains below the trend pre-Covid, so there are still a number of workers who stopped seeking work after the pandemic (which is what caused the massive hiring and wage battles that followed, significantly adding to inflationary pressures over the last two years):
And therein lies the problem – there are fewer people returning to work after Covid, causing us to be fully employed as a country – the people in the job market now all have jobs. Without either more workers coming back in, or businesses slowing down enough to no longer need more workers, we are stuck in this wage-price spiral I described above.
What this means to you
We continue to see the job market soften slightly, but we have a LONG way to go to ease off of wage pressure. This will come in two ways, which the Fed is counting on. First, the economy must be slowed down enough that the demand for workers drops substantially. Second, prices and cost of living will remain elevated long enough to force many of these former workers back into the job market. The problem is, many of the people who exited the job market after Covid were near or at retirement age already, so most won’t be coming back. The only solution, then, is to slow down the economy.
It’s getting harder to obtain a loan
Like most of the world’s economies, the United States operates on something called a fractional reserve monetary system. It’s complicated to explain in a brief blog post, but basically it means that money is created by our banks lending it out, businesses and individuals using it productively, and paying it back to the bank, plus interest. Banks are allowed to lend money they don’t have based on the deposits their customers put in the bank. Essentially, banks just invent money out of thin air each time they lend.
More money in the system means prices go up, because there are more dollars out there to spend on the same number of goods and services (or in an ideal economy, the number of products and services are growing, too, because businesses borrowed the money to go into business, expand their operations, etc.). But when you have gobs of new money and no productive output, inflation soars. This is precisely what happened during Covid, when the government, through banks, lent huge sums of money – almost $6 trillion – and gave us stimulus checks and Paycheck Protection (PPP) loans to businesses that they immediately forgave. So all of that money is now floating out there in the economy with the same (and in many cases, fewer) products and services to spend it on. Thus, prices went nuts and you and I are living with the economic mess that resulted.
The Fed is trying to reverse that overflow of money through a process called quantitative tightening. They are raising interest rates to make loans less affordable (so you’ll borrow less), make your savings account pay you better (so you’ll save more and take that money out of the economy for now), and they themselves are drawing money back into the Federal Reserve System to reduce the amount out there. All of this strengthens the dollar in terms of buying power, which will lower the asking price of many items.
The side effect of all of this monetary action is, borrowing slows, investing slows, and production slows: a recession. In that sense, a recession isn’t a good thing, but it’s a necessary thing, to drain excess liquidity out of economies that get “too hot” for too long.
We are starting to see the effects of the quantitative tightening really take effect now. It’s becoming much more difficult to obtain credit for businesses and consumers:
There are two reasons for this. The first is, depositors have been scared away from saving money in banks, particularly smaller banks since the failures of Silicon Valley Bank, Signature Bank, and others a few weeks ago. Depositors have moved a huge amount of money out of banks and into money market funds for now:
Without deposits, banks are restricted on how much they can lend. And we can see a massive drop-off in new loans issued in the past few weeks:
Banks are also dropping their investments in mortgage-backed securities at the moment. It had been trending down for all of last year, but fell off a cliff last week:
To help offset the drop in bank lending for real estate especially, the Federal Home Loan Bank has issued a massive amount of new bonds to guarantee bank loans for property purchases in the coming months. This means banks are less and less willing to assume the risk of a mortgage loan without a government agency guarantee.
You can clearly see the banks’ sudden disinterest in funding real estate projects, especially commercial real estate (which I believe will see an almost catastrophic decline – see below):
The banks have tightened so much already that we are at or near typical levels felt during recessions:
Consumers are also lowering the bank’s lending simply by buying less on credit. As interest rates on their credit cards soared over the last year, many consumers have slowed their use of credit automatically (though I’m concerned seeing consumers putting a lot more of their service purchases on credit – does this mean medical bills, airline flights, vacations, and even things like restaurant dining might be now going on a credit card)?
Banks and consumers are right to be concerned. Bankruptcy filings are climbing rapidly, and loan delinquencies are soaring:
What this means to you
Higher interest rates will be good for your cash savings, but bad for borrowing. This is the intention of the interest rate hikes, because they incentivize people to slow down their risk-taking and borrowing, and instead put their cash on the sidelines. We believe these lending stats prove we are on the cusp of the economic slowdown we’ve long predicted.
Commercial Real Estate has serious problems ahead
We believe all of real estate will suffer a significant recession, but the worst hit will be commercial real estate, already struggling with high vacancy rates following the “work from home” mania brought on by Covid. As companies reduce their floor space as many workers take up a home office for all or part of their daily work activities, we believe this trend will worsen until there is a serious correction in office and commercial property.
The office vacancy rate is already higher than it was at the peak of the 2008-2010 recession:
With offices in downtown areas at the highest vacancy rate recorded since the Great Depression:
And spaces listed for rent have soared. We believe this will eventually lead to significantly lower rent rates for commercial real estate, and unfortunately, the failure of a number of commercial real estate ventures as demand simply won’t be back to pre-Covid levels for years (if ever):
There are fewer investors interested in financing commercial real estate ventures, also, as the number of Commercial Mortgage-Backed Securities collapsed so far in 2023.
This has forced many commercial developments to seek financing directly from banks, with smaller local and regional banks picking up the slack (black portion of the bar):
We believe this continues to add to the woes of the smaller banks, which are the ones who have had such noteworthy failures in the last few weeks. We believe this will continue.
What this means to you
The fact that commercial real estate will fall significantly isn’t a surprise to our readers. We’ve said real estate as a whole was going to suffer a substantial retraction this year from the preposterously high valuations of the last few years. What is a greater concern now is the over-reliance on small and regional banks that real estate has made over the last several years. If there are substantial failures of real estate lending (foreclosures, bankruptcies, etc.), these smaller banks will be seriously affected. Our advice is to make sure you are using FDIC insurance guidelines and never keep more than $250k in any bank account. Use money markets and brokerage accounts and money market funds for larger balances.
We also believe this will be a good time to renegotiate rent for our small business customers, and consider relocating and locking in longer leases as conditions in this sector worsen.
We strongly urge you to follow the daily updates if having a daily look at the changing economy is vital for your investments or business activities. You can do so by visiting Think Like A Rich Guy.
Bottom Line:
Download our brand-new E-Book “7 Hacks To Recession-Proof Your Financial Life” today.
We are at the economic tipping point. We’ve been alerting our clients for over a year and a half that inflation was going to cause significant problems and our central banks would have to take progressively stronger actions to combat it. That appears to have been a correct call.
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 predicted the beginning of a turn in the current market rally last week, and we reiterate that sentiment now. There will always be market movement that moves 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 market participants. We do believe, however, that the recent rally has fully run its course, and there will soon be a strong shift from stocks into safer investment options such as corporate and government bonds. 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.
Just this past month, 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:
Watching This Week:
- Jobs Report
- Service Sector Update
- Commodities
