Everyone’s doing it! As the economy and a recession flirt with each other in a classic case of ‘will they or won’t they’, it seems like most people are taking the risk, banking on ‘they won’t.’
It’s true – the U.S. economy appears resilient, and our leading indicators suggest we are not in a recession… yet. These indicators are starting to slowly deteriorate, though, and our team is 100% certain that the soft-landing narrative that seems to be baked into the pricing of risk assets is incorrect which means prices are inflated. We expect the pricing of risk assets to inflate even more in the coming months.
As always, we break down the facts below so you can understand why we’re exercising caution.
Housing: Since January 2022, new home sales have declined by 27%, and existing home sales have declined by 40%. It’s clear that new home building activity has slowed considerably and the tight inventory means that existing home prices are holding steady and even going up. In January 2024, a whopping 24.0% of homes in the U.S. sold above list price, up 2.8 points.
With limited supply and high-interest rates, home affordability continues to be a challenge. The U.S. housing affordability index was barely above 100 in December 2023. Translation: the typical family will be challenged to buy a home based on the median-priced home. As the business cycle turns and more companies start to lay off employees, we’ll see a resurgence of homeowners defaulting on payments, thereby putting downward pressure on home prices.
Inflation: According to the Bureau of Labor Statistics, the Consumer Price Index for All Urban Consumers (CPI-U) increased by 3.1% over the last 12 months. Truflation, on the other hand, is pegging the U.S. inflation at just 1.71%. (Truflation’s estimate is based on 12 million data points from 30 data sources and, in our opinion, is a much better estimate.)
If Truflation is indeed more accurate, it will be too late when the Fed finally realizes its mistake. The damage to the economy will have been done and the Fed’s only option will be to try and avoid a deflationary scenario.
Jobs: The job market is still looking strong. Initial jobless claims in the United States decreased to 201,000 in the week ending February 17, 2024. This is down from 213,000 in the previous week. Even more encouraging, the U.S. economy added 353,000 jobs in January 2024. More people working leads to more cash in their pockets and higher consumption – all serving to keep the business cycle humming.
Manufacturing: The Institute for Supply Management (ISM) Purchasing Managers Index (PMI) is at a current level of 49.10, up from 47.10 last month and up from 47.40 one year ago. This is a 4.25% increase over last month and a 3.59% increase from one year ago. A very encouraging sign of a strong economy.
Fed Chair Jerome Powell can take his victory lap now, as all these indicators support the soft-landing narrative. We don’t think it will last long, however, as the lagging effects of tight monetary policy have not yet unleashed their full fury on the economy.
Here’s a synopsis of some of the danger zones we’re watching closely.
Banking System: It is on a weak foundation. The Fed conducts a yearly supervisory stress test on large banks as part of its supervision efforts. The goal is to assess whether banks are sufficiently capitalized to absorb losses during stressful conditions and evaluate how banks are likely to perform under hypothetical economic conditions.
The 2024 bank stress test scenarios include:
- A 36% decline in house prices
- A 40% decline in commercial real estate prices
- A nearly 6.5 percentage-point increase in the U.S. unemployment rate, peaking at 10%
Our analysis indicates that the scenarios outlined above by the Fed are generous, and what likely manifests will be much worse.
Meanwhile, the largest banks in America are planning a legal battle against new rules to hold more capital to better withstand the above risks. The banks argue that the new requirements are both unnecessary and harmful to the economy. We disagree. When those stress test scenarios do play out, the banking system will face a dangerous liquidity problem. Throw in credit card and auto loan delinquencies and we could see a few more bank failures.
Stock Market: The market continues to follow the path we laid out in our December 2023 blog. The S&P has already broken its all-time high record 12 times in 2024 and continues to march ahead unabated. Near term, all indicators point to a correction which would be positive for the medium-term bullish case, much like a battering ram coming back for more energy to break past prior resistance.
Trillions of dollars are on the sidelines, waiting for a pullback to enter the market.
From a practical standpoint, we see that small caps have lagged behind their mid and large-cap cousins for several months. We expect small caps to catch up and even outperform over the next few months as investors embrace the soft-landing narrative and take on more risk.
So, risk on for now, and we’ll keep a watchful eye out for you as things evolve. The economy and the recession will continue to play it coy, dancing around each other and keeping everyone guessing. But we’ve seen this movie before. In the end, they definitely ‘will.’
