Economic Letter

By Patrick Pascal

October, 2023

ECONOMY

Interest rates above recent market expectations may finally dampen consumer activity. The Conference Board reported that its Consumer Confidence Index declined to 103.0 in September, down from 108.7 in August. The report also noted that the six-month expectations reading fell below 80. Such low readings often precede recessions.

Last week, Citibank CEO Jane Fraser said, “We are paying attention to the lower FICO consumer, where there are cracks” adding “I think some of the excess savings from the Covid years are getting close to depletion.” As we have noted in our past two letters, after peaking at $2.4 trillion, “excess” household savings has been steadily declining since 2021 and has variously been calculated to return to historical (nominal) levels during the current quarter.

According to a recent Chicago Federal Reserve Bank study, relative to a baseline scenario, as of Q3, quantitative tightening has cumulatively reduced real GDP by 5.4%, the CPI by 7.1 points and reduced aggregate hours worked by 4%. This same study predicts that the lagged effects from past tightening will subtract another 3% from real GDP over the next five quarters, 2.5% from the CPI over the next four quarters, and 6% from hours worked over the next eight quarters.

Many businesses and consumers took steps to lock in the extremely low interest rates quantitative easing brought during the pandemic. Moody’s Analytics calculates that, as of the first quarter of this year, only 11% of outstanding household debt carried rates that fluctuated with benchmark interest rates. Many corporations have also extended debt maturities at favorable rates. This dynamic appears to have lengthened the lags between rate hikes and economic slowing and may help explain why past interest rate increases have not brought the slowing the Fed desires.

FIXED INCOME

Uncertainty over the course of monetary policy remains elevated. After recently rising to a decades-high 4.88%, 10-year US Treasuries yields pulled back slightly in reaction to the current conflict in the Middle East.

Core U.S. inflation has cooled somewhat over the past six months. The latest private sector employment creation data has also shown nascent slowing. We think the Fed may be nearing the end phase of interest rate increases.

Therefore, we favor properly laddered, medium-term investment grade corporate and government bonds to lock in current higher yields and remain vigilant to take advantage of future longer-term bond opportunities.

EQUITIES

The sell-off of September, combined with generally rising earnings guidance has improved equity values. For example, the technology sector recently traded under 24 times its projected forward 12-month earnings, down from over 28 in July. The S&P 500 Index now trades at just under 18 times future earnings. With inflation running near 4% and fixed income offering around 5%, these valuations appear reasonable.

In hindsight, just as the good corporate news of July (earnings, future guidance) provided a selling opportunity, selling related to developments in the Middle East and Ukraine, may well produce compelling buying opportunities.

The market’s muted response to the tragic hostilities which began on October 6 is notable. During the October 1973 Yom Kippur War, the S&P 500 Index also reacted mildly falling just 0.6% over the first five days before recovering. Today, the Index is up about 1.0% since the onset of bloodshed. In 1973, gold initially rose about 6% before finishing October essentially unchanged. This October, gold has reacted even more calmly rising just 2%.

Investors may be wise to tread cautiously though. Responding to U.S. support for Israel during the Yom Kippur War, the 1973 Arab-led oil embargo quadrupled the price of a barrel, while the S&P 500 Index fell over 40% and the price of gold rose over 50% within one year.