US Strategy Weekly: It Is Different This Time

Recent economic releases suggest inflation is reaccelerating while the economy and the consumer may be decelerating. In normal times, these opposing trends would be fine since a slowdown in the economy would be enough to curb inflation in the coming months or quarters. But these are not normal times. It is an election year. And in the pre-election and election years the party in power in the White House often gives the economy a boost. The reasoning is obvious; voters tend to boot incumbents out of the White House during a recession.

As we show on page 7, inflation has never been as high as it was in 2022 without eventually triggering a recession. Moreover, a Fed tightening cycle, particularly when it is fighting inflation, has rarely ended without the real fed funds rate hitting a minimum of 400 basis points and eventually triggering a recession. However, the recent peak in the real fed funds rate only hit 290 basis points before the Federal Reserve paused rate hikes. Whether the Fed felt rates were high enough to calm inflation, or if they were fearful of triggering a recession, is unknown. But in our view, interest rates were not particularly high given the level of inflation, and therefore, were likely to stay higher for longer.

But again, these are not normal times. The main difference in this cycle, in our opinion, is the four consecutive years of massive fiscal stimulus. We have found it difficult to track the various forms of stimulus employed by the current administration, but it is worth looking at the White House website at https://www.whitehouse.gov/american-rescue-plan/ to see the various forms of relief offered to American families. Most of these are family and small business assistance programs and do not include the aid given to illegal immigrants, the $5 trillion in pandemic stimulus, President Biden’s Inflation Reduction Act (Goldman Sachs estimates the IRA fiscal cost to be $1.2 trillion), the Bipartisan Infrastructure Bill and Build Back Better Agenda, or the estimated $56.6 billion of student loan forgiveness delivered through the Department of Education’s new SAVE program. This steady stream of fiscal stimulus is boosting economic activity in ways that are impossible to measure accurately, but it is an external stimulus, and it means these are not normal times.

Massive fiscal stimulus is typically seen only during major recessions, and it is unsustainable in the long run. Plus, as we noted in our US Strategy Weekly Inflation Redux (April 17, 2024), stimulus programs mean bigger deficits and mounting debt will ultimately translate into higher interest rates and slower economic growth. In fiscal 2024, interest outlays on the federal deficit are estimated to be 3.1% of GDP and net interest costs account for 13% of current federal outlays.

Without strong leadership in Congress, deficits and net interest costs will undoubtedly move higher. To the extent that there is a steady increase in demand for US Treasury securities the US will be able to fund these deficits. But the supply/demand balance for any security can shift very quickly. For this reason, we believe one of the biggest risks in 2024 could be found in the debt markets. In fact, the debt markets may eventually become the disciplinarian needed to put the US, and Congress, on the road to fiscal responsibility. In sum, debt markets are key to this cycle!

Economic Weakness

After some modest improvement in February, the March University of Michigan consumer sentiment survey showed weakness across the board. The Conference Board confidence index fell significantly in March and February data was revised downward. Consumer expectations in the Michigan survey were the lowest since December and in the Conference Board survey, expectations were the lowest since July 2022. See page 3.

The University of Michigan sentiment surveys are extensive and on page 4 we show sentiment by level of education and political affiliation. Those with a college degree tend to be the most optimistic most of the time, but sentiment for all levels hit a record low in 2022. Nonetheless, March data showed a noticeable improvement in sentiment for college grads. Conversely, sentiment fell for those with a high school degree or less. Politics plays a role in sentiment and optimism tends to rise when your political party is in power, which explains why Republicans have been so glum in recent years. But while sentiment in general remains well below the 100 neutral level, there has been a bit of improvement in sentiment, particularly for independent voters.

After growth of 4.9% and 3.4% in the last two quarters of 2023, preliminary data for first quarter GDP showed growth slowing to 1.6% (SAAR). Some of the drivers of first quarter growth were fixed residential investment, computer & peripheral investment (artificial intelligence?), services, and farming. The prospect of interest rates remaining higher for longer suggests that the housing market could see less growth in coming quarters. If so, a soft housing market could slow GDP further. See page 5.

Inflation Rebounds

The March personal consumption expenditure deflator was up 2.7% YOY, higher than the 2.5% YOY seen in February, and higher than expectations. While the uptick appears small, the components of the deflator show that only goods inflation was flat. Services, energy goods & services, and the PCE excluding energy, food, and housing all trended higher in March. The core PCE deflator was unchanged at 2.8% YOY in March. See page 6.

The employment cost index showed that total compensation for private industry workers rose 4.2% YOY in the first quarter of 2024 versus the 4.8% YOY seen a year earlier. Wages were the driving force, rising 4.4% YOY in the first quarter, while total benefits increased a smaller 3.7% YOY. See page 8. The Fed may focus on wage gains since inflation could prove more difficult to control with the CPI increasing 3.5% in the same quarter as wages are increasing 4.4%. Keep in mind that wage costs feed into every area of the economy and result in higher prices for consumers. One reason inflation has been difficult to control in the past is that once price gains become embedded in the economy, a vicious circle of higher prices, higher wages, is difficult to break. Only a recession can reverse the cycle.    

Technical Update All four of the popular equity indices have recently tested their 100-day moving averages and to date, with the exception of the Russell 2000 index, these rebounds appear successful and are in line with a normal correction. The Russell 2000 appears to be returning to its long-term neutral trading range of 1650 to 2000. See page 11. The 25-day up/down volume oscillator is at negative 0.50 and neutral after recording a 90% down day on April 12. See page 12. The 10-day average of daily new highs is 74 and new lows are 64. This combination of new highs and new lows, both below 100, is neutral. The NYSE advance/decline line made a new record high on March 28, 2024, confirming the advance but is now 6750 net advances away from its high. We remain cautious.

Gail Dudack

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