It Feels Like Something's Gotta Give
There may be trouble lurking under the surface of smooth-appearing seas.
Before I get into this article, I would like to acknowledge something.
Lately, I have been advocating for caution. I hope my readers aren’t finding me to be a “negative nellie.” I promise, I am not. When I believe the time is right to substantially increase allocations in the market, I promise that I will say so, and hopefully very unequivocally.
In a spirit of honesty, to this point in the year I have given up potential gains because I have not yet believed this to be the case. Specifically, as of July 31, my portfolio hit my personal high for the year. Still, my YTD return was “only” 7.03%. Interestingly, that was not much worse than the Dow, up a mere 7.28% during that stretch. But the S&P 500 and the Nasdaq have completely blown me away, up 19.52% and a whopping 37.07%, respectively.
Interestingly, it was almost a year ago to the day that I wrote the following article here on Substack.
In the article I specifically enumerated, in my view, why what I referred to as “the world of 4,818” no longer existed. And yet, during the market session on July 27, 2023, in the environment of a Fed enacting the fastest and sharpest interest rate increases in decades, that “world” did manage to hit an intra-day high of 4,607.
So, in a spirit of full transparency, I will say right here and right now, unequivocally, that I never saw that coming.
Under the surface, however, I continue to see some factors that trouble me. In this piece, I hope to share some reasons for this concern, hopefully without hyperbole and also from quality sources. Use or ignore it, please, as you see fit. Either way, my conscience will be clean.
Interview with Mary Daly - San Francisco Fed President
Last week, the latest CPI numbers were released. The consumer price index rose 3.2% from a year ago in July, a sign that inflation has lost at least some of its grip on the U.S. economy.
Excluding volatile food and energy prices so-called core CPI also increased 0.2% for the month, matching the estimate and equating to a 12-month rate of 4.7%, the lowest since October 2021. The annual rate for the core also was slightly below a Dow Jones consensus estimate for 4.8%.
Following the release, Jennifer Schonberger of Yahoo Finance scored an exclusive interview with San Francisco Fed President, Mary Daly. (NOTE: If you are interested in listening to the full 9-minute interview, feel free to use the above link.)
Here is a brief synopsis of the interview, and how at least this non-voting member of the Fed board sees things at the present time.
Certainly, the headline numbers looked good. With respect to this, however, Daly offered a caution.
“What I always say is that Americans pay for gas and food. So while they are volatile and they move around a lot, those are headline numbers that hit people directly in their pocketbooks.” (Bold mine)
It is precisely because of this, said Daly, that core inflation becomes very important. Since the Fed doesn’t really have tools to control the prices of gas and food, as they are traded on global markets, the focus on getting core inflation back to pre-pandemic levels is critical, because this at least gives families some buffer to deal with volatile gas and food prices. On the other hand, if core inflation stubbornly remains high, volatile gas and food prices cause great distress, particularly for families on the lower end of the economic spectrum.
Moving on, she offered what I thought to be a little interesting color around the “data dependence” we consistently hear so much about from the Fed. Daly said she preferred to think of what they do in terms of information, as opposed to simply data.
What is the difference? Daly clarified that, in addition to numeric data, the information they work with includes real-world interviews with, for example, business owners, in an effort to understand what is truly going on out there “on the ground,” so to speak. Here is how she summarized this part of the interview.
“I see slowing in the economy but not there yet. And that is what my contacts in the district tell me . . . Yes the economy is slowing down, yes it feels less frenzied, but boy it’s still hard to find workers. If you’re a worker, it’s still hard to afford things, even though you’re making good wages.” (Bold mine)
She went on to say that such information highlights that things still aren’t quite in balance, and this is what the Fed needs to factor as they make ongoing decisions.
Asked her view of the future, Daly replied essentially as follows. In the June summary, the median projection was that two more rate increases would be required. The ongoing question is; does anything change that outlook? Certainly, the most recent CPI report was a positive data point. However, what if there is a spike in volatile gas and food prices? What if the recent positive trend in core services ex-housing inflation stalls out? These are factors that need to be closely monitored.
I will leave you with the conclusion of her interview as a direct quote, because I think it important to share the exact words she chose to use.
“The real piece where we are going to be doing a lot more thinking and watching is in this core services ex-housing, supercore some people call it. That is a big component of spending for people and it is something that has really not made much progress so far. Now that’s not surprising, really, because it is less interest-rate sensitive, but we do need to see that come back to pre-pandemic levels if we are going to be confined that we can get to 2% on a sustainable basis, and I’m going to need to see some traction in getting there before I feel comfortable that we have done enough.” (Bold mine)
I found that last quote to be telling because, as I looked through the latest numbers myself, I could see exactly what Daly referred to, that core services ex-housing inflation is proving to be a little stubborn. Interestingly, in a December, 2022 article, I featured Jerome Powell’s comments on this issue, along with supporting graphs. The fact that this continues to prove challenging, I believe, bears watching.
Consumer & Household Debt Continues To Rise
Roughly two months ago, I wrote an article entitled Rising Consumer Debt Portends A 10% Correction In This Market.
If you haven’t had a chance to read it, I suggest that it would be well worth your time. In addition to perhaps the most troubling implication, namely that poorer families are having to use credit cards to pay for essentials, the article featured the fact that even families who are doing quite well financially are using credit card debt to finance a desired lifestyle to which they have become accustomed. I share a most interesting anecdotal account of this from The New York Times.
As of that last report, credit card debt was holding steady at roughly $986 billion, and the question was: When would this cross $1 trillion?
We now know the answer. It happened in Q2 2023, according to the latest report from the New York Fed. According to the report:
Credit card balances increased by $45 billion, from $986 billion in Q1 2023 to a series high of $1.03 trillion in the Q2 2023, marking a 4.6% quarterly increase. Credit card accounts expanded by 5.48 million to 578.35 million. Aggregate limits on credit card accounts increased by $9 billion and now stand at $4.6 trillion.
Summarizing that report, a recent CNBC article summarized this as a value of $5,947 for the average consumer. Finally, while a blog summarizing the Fed report stated that there is not yet evidence that families are facing high levels of distress, I couldn’t help but note that delinquencies were starting to trend upwards.
Putting The Pieces Together
Here’s where I see the tie-in between this data point and the interview from Mary Daly summarized in the section above.
In one of the featured quotes, Daly said that on-the-ground interviews expressed the thought that “If you’re a worker, it’s still hard to afford things, even though you’re making good wages.”
And that’s how it feels to me. That, while good progress is being made in the overall picture, there may be more people than we think that are just one event, such as the loss of a job or a health challenge, away from some real trouble.
Lastly, I am really struggling to figure out how the current housing impasse is going to be resolved. In short, as best I can piece it together, housing prices have been able to remain high because there is almost no inventory of homes for sale. And why is this? In large part, because those fortunate enough to have obtained low mortgage rates circa 2020-2021 are now trapped. They cannot move because the mortgage they would need to assume at current rates in order to do so would be prohibitively expensive.
The problem is; something is going to have to give. Either interest rates need to come down, and the only way this will happen is if we enter a recession, or prices have to fall, causing household net worth to decline and likely spending to slow as a follow-on.
In my last article, I revealed that during July I added 4% to my cash reserves, electing to decrease my allocation to U.S. stocks and REITs by 2% each. That decrease in REIT weighting actually took my normal 5% allocation all the way under 2%. As an extremely interest-rate sensitive sector, that one caused me particular concern.
I will share that, as of this morning, two limit-buy orders triggered for me on VNQ at prices roughly 5% where I sold those shares just a few weeks ago. I have similar limit-buy orders pending at levels between roughly an additional 3-10% lower in the event this trend continues.
I hope this information has been of some use to you. I’d love to hear your thoughts in the comments below.