A historic year

This week I dodged the hurricane bullet as I traveled to Orlando, New Orleans and Richmond, presenting on AI, the economy/markets and the election. An advisor in Orlando got incorrect tax rates from ChatGPT three times, before advising it to just get info from the IRS website. “Noted and updated,” was its response. Hmm. But in New Orleans, an advisor knows a radiologist who uses AI to compare his patient’s image with 10,000 others, assisting in diagnosis. Yes! My light-hearted conservative-leaning Richmond audience made its political opinion quite clear, but voiced particular concern about AI taking jobs, and too much love for tech stocks. Is there a German word, I wonder, for being relieved because something was awful but not quite as terrible as you feared? That’s how I feel about Hurricane Milton. Perhaps that’s also a metaphor for the economy’s resilience even in the face of misfortune. After all, the index of leading economic indicators has produced the worst three quarters in all of its 65-year existence this year—and yet, knock on wood, we have been fine. It has been a historic year, where all the standard measures of doom—remember the yield curve, the Sahm rule?—have been, so far at least, mistaken. For now, the economy appears to be durable, if stuck in the calm before the electoral storm—with far more companies mentioning the election in 2Q calls than did so four years ago. Investment activity typically picks up after an election, which may see capex increase, with political uncertainty removed and rates decreasing. We saw jobless claims jump this week to 258,000, the highest since June 2023. Ever since the Sahm rule was triggered, rising joblessness has been a concern, but this appears to be legitimately weather related, not recessionary. The two hurricanes (which are themselves inflationary, as they disrupt supply chains and cause demand surges) arrived just as we saw the China stimulus, oil creeping higher, the risk of further escalation in the Middle East and big pay raises for longshoremen on the East Coast. It looks almost like 1970s inflation but without the crucial scarcity in the energy supply. Among the first victims: North Carolina homeowners, who may find their insurance jumping by as much as 50-100% in the wake of Helene.

This week’s CPI report was discouraging (more below), but the worry is that it’s not just one off month—and that the cure will be unpleasant. Mortgage rates are up 0.4% over just the past three weeks. This has not yet dented prospective buyer optimism whereby 42% of buyers (the most since 2010) see mortgage rates falling over the next year, an important metric since rates have risen to 6.3% and 72% of prospective buyers say 5.5% is the highest mortgage rate they consider acceptable. A shortage of housing has kept demand strong even at current rates. If housing inflation (5.3% y/y) were still at pre-Covid levels (3.5% y/y), we would already have brought core PCE down to roughly 2%. Another sign that affordability is broken: 23% of respondents now say they never expect to be able to afford to buy a home versus 19% pre-Covid. There are other causes of inflation to worry about too: oil prices, homeowner’s insurance and storm-related demand to name a few. The recent increase in bond yields suggests the market may be worried that the Fed is moving too quickly. The Fed increased the M2 money supply by 36% (net) since the beginning of the pandemic. Inflation is up 22% over that same period. This could mean that inflation is not yet done with us. If it does recur, one source may lie with “supercore” inflation, which is core services inflation ex-housing. It rose from 4.3% to 4.4% in the latest CPI report. We’ll need to break with history once again if we are to escape a second bout of inflation: the chances of a 6% wave of inflation recurring are roughly 90%, in multinational data going back 100 years. Tough odds!

And yet while there are always causes to worry, maybe it isn’t so bad. For one thing, there’s a lot of cash on the sidelines. Money market balances rose to a hefty $6.4 trillion. That dry powder may embolden investors to buy the dips if the runup to the election has a rough patch or two in store. And if the Fed continues to pare the short-term rate, those investors may find themselves willing to assume a bit of risk. For another, the stock market looks healthy. We’ve had 44 all-time highs this year (!), and breadth is much improved, while sentiment is not yet so bullish as to serve for a contrary indicator. It has not just been tech stocks bringing the market higher either—the equal-weighted S&P is close to a new high and 85% of S&P 500 stocks are up y/y. Operating forward earnings for the S&P 500 rose to a record high earlier this month, indicating that for now the bull case remains intact. Furthermore, the VIX level is quite high relative to narrowing credit spreads (top 5% historically), and high-yield spreads are at their lowest level since before the Global Financial Crisis. Usually, this means that the bond market is right and the stock market is wrong—a situation that typically gets rectified by the VIX coming down as equity prices rise. The S&P 500 is up 19.4% year-to-date, the strongest this century to this time of year. If the S&P 500 stays flat into year-end, it would be the eighth-best year this century. Though often challenging in a presidential election year, October seasonality now puts the wind at our back. As for an economic slowdown, which certainly feels like the biggest investor concern, the Atlanta Fed’s GDPNow tracker indicates Q3 GDP growth of 3.2%. This century, Q4 has been up 19 out of 24 times, more than any other quarter. (Nice odds!) Hang on tight, in what is truly a historic year.

Positives

• Wholesalers happy The Producer Price Index came in a bit lower than expected with the headline number unchanged m/m and up 1.8% y/y against expectations of a 0.1% monthly increase. As often lately, the challenge lay on the services side, with prices for final demand goods falling 0.2% while services increased 0.2%.
• Consumer credit slows, trade deficit retreats Consumer credit outstanding rose slightly less than consensus due to a decline in revolving credit and slower growth in non-revolving. Separately, the trade deficit ticked lower by $8.5 billion in August to $70.4 billion. Exports rose by 2% m/m while imports fell 0.9%.
• Synchronous global easing The New Zealand central bank cut rates by 50 basis points, in order to prevent a slowdown from developing. Meantime, India kept rates unchanged but shifted their stance to “neutral,” which might lead to the first cuts in four years starting in December.

Negatives

• Consumers unhappy The CPI increased 0.2% in September m/m and core rose 0.3%, both numbers 0.1% above consensus. This continues the somewhat disappointing August report and comes after several months (May-July) where inflation fell. Yet though it was a miss, it was a quirky one: set aside owners’ equivalent rent, and y/y CPI is far below target. Still, the recent increases in the 3-month annualized rates of inflation are cause for concern.
• Consumers chagrined The University of Michigan’s consumer sentiment survey declined to 68.9 in October from 70.1 in September. Frustration over high prices was blamed for the decrease in sentiment as consumers await the outcome of the election.
• Small businesses upset Small business optimism as measured by the NFIB index rose to 91.5 in September against expectations of 92.0. Firms calling this a good time to expand remained at a paltry 4%. Interesting that this should be so, given this month’s favorable labor report. Business uncertainty jumped to a record high.

What Else

Golden goose The UK has seen its largest-ever wave of immigration over the last two years, mostly from outside the EU. As with a similar migration wave in the US, this has not always been popular, but it has helped economic growth. We appear to be in a time when immigration is politically dicey but economically necessary.

Getting pricey The S&P 500’s forward P/E has gone up from 15.3 in October 2022 to 21.6 today. In 1999 it was 25.5. Relative to bond yields, the US is the most overvalued equity market of all right now. China and Hong Kong are the most undervalued, and Italy is the most undervalued of Western markets.

Virtual democracy Only one person will be elected president next month, but thanks to an immersive new exhibit at the White House visitors center, everyone can now picture themselves behind the Resolute Desk signing legislation. The $56 million installation is said to be a lot like an Apple store, with a State Dinner feature that’s “just bonkers”!