Dear Clients & Friends,
It’s mid-month and time for our monthly economic risk update. Though these updates are usually intended to give a brief snippet of our current economic climate, this summary will be most beneficial for considering the status of the American economy, and its progress, during the last four years. I think it’s natural for people to be confused about the economy in an election year. The incumbent wants the public to believe that the economy is doing well, and the opposition wants the public to believe the contrary. This time, it’s a little different - because there is no way to hide the massive stock market boom that we’ve witnessed over the last few years.
The only justifiable argument is whether or not this boom will last. We hear talking heads on the news questioning a hard or soft landing on a daily basis. Let me be clear: we’ve already landed! The wheels are on the ground! Inflation is below our 100-year average, the labor market is basically full, the stock market is up 65% since inflation became a recurring discussion, and the markets are all at, or recently made, all-time highs. However, the aircraft still needs to come to a safe stop, and the Fed’s job is not yet complete. Poor or erratic braking has the potential to veer the aircraft off the runway and blow the landing. That being said: we’ve landed, the wheels have touched down, and it was so soft you didn’t even notice!
This is where we are as we head into late October, Halloween, and the next Presidential Election. (Oye Givult!) For this update, we chose from our usual set of metrics so that our audience can follow along from month to month. We also want to mention our good friends Sam Millette and Brad McMillan for their insight and contributions to our Risk Updates.
Service Sector
Service sector confidence improved in September, with the index rising from 51.5 in August to 54.9 in September. This result kept the index in expansionary territory for the month and brought the measure above its starting point for the year. It remains to be seen if the break from the overall downward trend can be sustained.
Private Employment
254,000 jobs were added in September, following an upwardly revised 159,000 jobs in August. This marked 45 consecutive months of job growth, and the unemployment rate ticked down to 4.1% in September. This is incredible -almost 4 full years of job growth! Historically, full employment is 96%. (There will always be a small gap due to a variety of factors, such as geographic job placements.) Currently, we are at 95.9% employment. The labor market is maxed out. Never in modern history has a central bank been able to fend off inflation in only two years without completely destroying the labor market. Make no mistake about it - the United States of America has an incredibly strong labor market right now, and it is truly the primary reason for the economic boom we’ve witnessed since the COVID crisis subsided.
Yield Curve
As I always say, this metric is a bit more involved. For the purposes of simplicity, let’s remember that shorter rates tend to be lower than longer rates. A 1-year CD usually pays less than a 5-year. A 10-year mortgage rate tends to be cheaper than a 30-year mortgage rate. Simply put, this is because the longer you (or a bank) has to lock up money, the more risk is involved. More risk should equal more return. Thus, you get a higher interest rate for a 5-year CD than a 1-year CD and a bank gets a higher rate for a 30-year mortgage vs a 10-year mortgage.
When the yield curve inverts (meaning that longer rates are lower than shorter rates), it’s often a precursor to a slowing, or possibly failing, economy. The US yield curve is currently inverted.
The yield curve inversion narrowed slightly during the past month. The 10-year Treasury yield fell from 3.91% to 3.81%. The 3-month Treasury yield fell from 5.21% in August to 4.73% in September. The yield curve has now been inverted for two full years. However, with rates heightened to stave off inflation, most economists expected rates to decrease in the short term. Therefore, an inverted rate curve in this climate is not necessarily alarming - at least not right now. We’ll see how the curve shape changes over the next few months.
Consumer Confidence
We follow the Consumer Confidence Index very closely, but what we found even more compelling is the year-over-year change in the Index. As you can see from the graphs, confidence has been fairly stable over the last two years, though we’ve seen a slight downtick recently.
Consumer confidence fell from 105.6 in August to 98.7 in September. It fell 5.37% on a year-over-year basis in September, marking seven consecutive months of declining year-over-year confidence. This metric earns a yellow flag.
Technical Momentum
We start to pay attention when a market breaks through its 200-day average; a breakthrough of the 400-day average can often signal trouble ahead. Technical factors supported major U.S. equity markets in September. All three major indices ended the month above their respective 200-day moving averages. This is quite good as a representation of positive market sentiment. However, this could easily be misconstrued as complacency instead of confidence. Hence the next metric set…
Market Complacency
We find two metrics to be very handy in measuring market complacency. First, we divide market valuations by market volatility. This is a way to look at how expensive the market is divided by how much people are worried. Complacency is often associated with high valuations and low volatility as measured by the VIX.
Time periods such as the year 2000, the time period between 2006–2007, and the year 2017 saw peaks in this index. Market drawdowns occurred roughly one year after those peaks. Market complacency increased slightly in September, with the index rising from 1.10 in August to 1.21 in September.
The other complacency metric we like to use is margin debt as a percentage of the market size. Margin debt is a way to borrow against your own portfolio, leveraging it to increase investment profits. Margin borrowing can therefore indicate confidence in the markets. But too much leverage can also indicate complacency, and large spikes in debt levels have typically preceded a market drawdown. While margin debt fell over the summer, debt as a percentage of market capitalization rose. These two metrics together are highly alarming.
Conclusion
While caution is warranted, we have been very pleased with America’s economic health over the last few years. Everyone’s portfolio has felt it, and we remain steadfast in our belief in the strength of the U.S. economy right now. Inflation is considerably lower than it was two years ago – it’s actually below our nation’s long-term average. And the labor market - the most important part of a capitalist economy - is robust.
I imagine that the election (and all of its misinformation) will propagate even more volatility. We are witnessing multiple wars around the globe with no end in sight. In addition, I can almost guarantee a market pullback of at least 5-10% within the next year - because that’s how the market works. That being said, the U.S. economy is somewhere between “pretty decent” and “very strong” by every available metric.
We wish everyone a totally creepy and spooky weekend!
-Matt and the Gurus at MORWM