The Impact of Higher Interest Rates on Real Estate

At the beginning of March 2022, the U.S. 10-year Treasury Bill interest rate hovered around 1.8%. By January 2024, that same 10-year rate hovered around 4%, more than doubling in less than two years.

As a result, U.S. commercial real estate prices fell more than 11% between March 2022, when the Federal Reserve started hiking interest rates, and January 2024. The potential for steeper losses has chilled the market and still poses potentially significant risks to some property owners and lenders. (1)

On the residential side of the real estate market, the national median price of an existing home rose 5.7% over the year that ended in April 2024 to reach $407,600, a record high for April. (2) Despite sky-high borrowing costs, buyer demand (driven by younger generations forming new households) has exceeded the supply of homes for sale.

Here are some factors affecting these distinct markets and the broader economy.

Slow-motion Commercial Meltdown

The expansion of remote work and e-commerce (two byproducts of the pandemic) drastically reduced demand for office and retail space, especially in major metro areas. An estimated $1.2 trillion in commercial loans are maturing in 2024 and 2025, but depressed property values, high financing costs, and vacancy rates could make it difficult for owners to keep up with their debt. (3) In April 2024, an estimated $38 billion of office buildings were threatened by default, foreclosure, or distress, the highest amount since 2012. (4)

In a televised interview on CBS’ 60 Minutes in February, Federal Reserve Chairman Jerome Powell said the mounting losses in commercial real estate are a "sizable problem" that could take years to resolve, but the risks to the financial system appear to be manageable. (5)

Locked-up Housing Market

The average rate for a 30-year fixed interest rate mortgage climbed from around 3.2% in the beginning of 2022 to a 23-year high of nearly 8% in October 2023. Mortgage rates have dropped since then, but not as much as many hoped. In May 2024, the average rate hovered around 7%. (6)

The inventory of homes for sale has been extremely low since the pandemic, but a nationwide housing shortage has been in the works for decades. The 2005-2007 housing crash devastated the construction industry, and labor shortages, limited land, higher material costs, and local building restrictions have all been blamed for a long-term decline in new single-family home construction.  The Federal Home Loan Mortgage Corporation, better known as Freddie Mac, estimated the housing shortfall was 3.8 million units in 2021 (most recent data). (7)

Many homeowners have mortgages with ultra-low rates, making them reluctant to sell because they would have to finance their next homes at much higher rates. This "lock-in effect" has worsened the inventory shortage and cut deep into existing home sales. At the same time, the combination of higher mortgage rates and home prices has taken a serious toll on affordability and locked many aspiring first-time buyers out of homeownership.

In April 2024, home inventories were up 16% over the previous year, but there was still just a 3.5-month supply at the current sales pace (a market with a six-month supply is viewed as balanced between buyers and sellers, but see the Latest Housing Data below.) The supply of homes priced at more than $1 million was up 34% over the previous year, which may help affluent buyers but won't do much to improve the affordability of entry-level homes. (8)

New Construction Kicking In

Newly built homes accounted for 33.4% of homes for sale in the first quarter of 2024, down from a peak of 34.5% in 2022 but still about double the pre-pandemic share. The growth in market share for new homes was mostly due to the lack of existing homes for sale. (9)

April 2024 was the second-highest month for total housing completions in 15 years, with 1.62 million units (measured annually), including single-family and multi-family homes. (10) This may cause apartment vacancies to trend higher, help slow rent growth, and allow more families to purchase brand-new homes in the next few months.

Renters are seeing some relief thanks to a glut of multi-family apartment projects that were started in 2021 and 2022 — back when interest rates were low — and are gradually becoming available. In the 1^st quarter of 2024, the average apartment rent fell to $1,731, 1.8% below the peak in the summer of 2023. (11)

We don’t want to see a dramatic decline in the number of new multi-family housing projects just as rents are starting to ease. Reducing housing inflation is essential to paving a path toward lower interest rates, but rents could rise again if the new supply drops significantly.

Effects Weave Through the Economy

By one estimate, the construction and management of commercial buildings contributed $2.5 trillion to U.S. gross domestic product (GDP), generated $881.4 billion in personal earnings, and supported 15 million jobs in 2023. (12) According to the National Association of Realtors, residential real estate contributed an estimated $4.9 trillion (or 18%) to U.S. GDP in 2023, with each median-priced home sale generating about $125,000. When a home is purchased (new or existing), it tends to increase housing-related expenditures such as appliances, furniture, home improvement, and landscaping. (13)

Both real estate industries employ many types of professionals, and developing new homes and buildings stimulates local economies by creating well-paying construction jobs and boosting property tax receipts. The development benefits other businesses (locally and nationally) by increasing production and employment in industries that provide raw materials like lumber or that manufacture or sell building tools, equipment, and components.

Shifts in real estate values, up or down, can influence consumer and business finances, confidence, and spending. And when buying a home seems unattainable, some younger consumers might give up on that goal and spend their money on other things.

If interest rates stay high for too long, they could accelerate commercial loan defaults, losses, and bank failures, continue to constrain home sales, or eventually push down home values—and any of these outcomes would have the potential to cut into economic growth. When the Federal Reserve finally begins to cut interest rates, borrowing costs should follow, but that's not likely to happen until inflation is no longer viewed as the larger threat.

Latest Housing Data

The latest housing data shows we may have seen a cyclical high for the housing market.

For April, the S&P Case-Shiller 20-City House Price Index was up again, increasing by 0.4% on a seasonally adjusted basis, but below forecasts. While the Index is rising to new highs, home price growth is slowing.

May New Home Sales fell 11.3% from the previous month, and prices are now 9% below their October 2022 peak. The number of months’ supply of new homes for sale jumped, rising to 9.3 months, reflecting inventory levels only seen in some of the worst housing recessions of the last 50 years.

The housing market is starting to come back to earth. It is a major unknown how long it will take to normalize or how swift its fall. If new home sales data worsens and existing home supply increases further, prices will inevitably come down. We don’t want to see mounting evidence of a housing market plunge, which would majorly affect the broader economy.

If you would like to review your current investment portfolio or discuss any other retirement, tax, or financial planning matters, please don’t hesitate to contact us at 734-447-5305 or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client, an initial consultation is complimentary, and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client and your financial plan and investment objectives are different.

1, 3) International Monetary Fund, January 18, 2024

2, 8, 10, 13) National Association of Realtors, 2024

4) The Wall Street Journal, April 30, 2024

5) CBS News, February 4, 2024

6–7) Freddie Mac, 2022–2024

9) Redfin, May 20, 2024

11) Moody's, April 1, 2024

What Persistent Inflation Could Mean for the U.S. Economy

Economic reports of late seem to point to a weakening economy and stubborn inflation.

On April 30, the Employment Cost Index for the first calendar quarter of 2024 showed a 1.2% increase (4.2% year-over-year); that was 25% higher than the consensus estimate of 0.9%.

The FHFA House Price Index for February 2024 was much hotter than expected, coming in at 1.2% versus 0.1% expected (7.0% year-over-year.) Similarly, the February Case-Shiller 20-City Home Price Index came in at 0.6% versus 0.1% expected (7.3% year-over-year.)

At the same time, two more economic reports were released on April 30.

The Chicago Purchasing Managers’ Index (PMI) came in at 37.9 (versus 45 expected).

The Conference Board’s Consumer Confidence Index also came in far below expectations (97 versus 104 expected).

The stock markets were understandably confused: Normally, lower economic activity means lower inflation. Instead, what we got was higher inflation and lower economic activity.

In the stock markets, confusion equals selling now and asking questions later. That’s what we are seeing now.

Persistant Inflation

On April 10, 2024, the U.S. Bureau of Labor Statistics released the Consumer Price Index (CPI) for March, and the increase in CPI — the most commonly cited measure of inflation — was higher than expected. The rate for all items (headline inflation) was 3.5% over the previous year, while the "core CPI" rate, which strips out volatile food and energy prices, was even higher at 3.8%. The month-over-month change was also higher than anticipated at 0.4%. (1)

The stock market then dropped sharply on this news and continued to slide over the following days, while economists engaged in public handwringing over why their projections had been wrong and what the higher numbers might mean for the future path of interest rates. Most projections were off by just 0.1% — core CPI was expected to increase by 3.7% instead of 3.8% — which hardly seems earth-shattering to the casual observer. But this small difference suggested that inflation was proving more resistant to the Federal Reserve's high interest-rate regimen (raising interest rates is one of the most common ways to curb spending and corporate investing to reduce inflationary pressures.) (2)

It's important to remember that the most dangerous battle against inflation seems to have been won. CPI inflation peaked at 9.1% in June 2022, and there were fears of runaway inflation similar to the 1980s. That did not happen; inflation declined steadily through the end of 2023. The issue now is that there has been upward movement during the first three months of 2024.(3) This is best seen by looking at the monthly rates, which capture the current situation better than the 12-month rates. March 2024 was the third increase month that points to higher inflation (see chart).

High for longer

While price increases hit consumers directly in the pocketbook, the stock market reacted primarily to what stubborn inflation might mean for the benchmark federal funds rate and U.S. businesses. From March 2022 to July 2023, the Federal Open Market Committee (FOMC or AKA the Fed) raised the funds rate from near-zero to the current range of 5.25%–5.5% to slow the economy and hold back inflation.

At the end of 2023, with inflation moving firmly toward the Fed's target of 2%, the FOMC projected three quarter-percentage point decreases in 2024, and some observers expected the first decrease might be this spring. Now it's clear that the Fed will have to wait to reduce rates. (4)(5)

Higher interest rates make it more expensive for businesses and consumers to borrow. For businesses, this can hold back expansion and cut into profits when revenue is used to service debt. This is especially difficult for smaller companies, which often depend on debt to grow and sustain operations. Tech companies and banks are also sensitive to high rates. (6)

As mentioned above, in theory, high interest rates should hold back consumer spending and help reduce prices by suppressing demand. So far, however, consumer spending has remained strong. In March 2024, personal consumption expenditures — the standard measure of consumer spending — rose at an unusually strong monthly rate of 0.8% in current dollars or 0.5% when adjusted for inflation. (7)

The job market has also stayed strong, with unemployment below 4% for 26 consecutive months and wages rising steadily. (8)

The fear of keeping interest rates too high for too long is that it could slow the economy, but that is not the case, making it difficult for the Fed to justify rate cuts.

What's driving inflation?

The Consumer Price Index measures price changes in a fixed market basket of goods and services, and some inputs are weighted more heavily than others.

The cost of shelter is the largest single category, accounting for about 36% of the index and almost 38% of the March increase in CPI. (9) The good news is that measurements of shelter costs — primarily actual rent and estimated rent that homeowners might receive if they rented their homes — tend to lag current price changes, and other measures suggest that rents are leveling or going down. (10)

Two lesser components contributed well above their weight. Gas prices, which are always volatile, comprised only 3.3% of the index but accounted for 15% of the overall increase in CPI. Motor vehicle insurance prices comprised just 2.5% of the index but accounted for more than 18% of the increase. Together, shelter, gasoline, and motor vehicle insurance drove 70% of March CPI inflation. On the positive side, food prices comprised 13.5% of the index and rose by only 0.1%, effectively reducing inflation. (11)

While the Fed pays close attention to the CPI, its preferred inflation measure is the personal consumption expenditures (PCE) price index, which places less emphasis on shelter costs, includes a broader range of inputs, and accounts for changes in consumer behavior. Due to these factors, PCE inflation tends to run lower than CPI. The annual increase in March was 2.7% for all items and 2.8% for core PCE, excluding food and energy. The monthly increase was 0.3% for both measures. (12)

Although these figures are closer to the Fed's 2% target, they are not low enough, given strong employment and consumer spending, to suggest that the Fed will reduce interest rates anytime soon. It's also unlikely that the Fed will raise rates.

The Fed seems poised to give current interest rates more time to push inflation to a healthy level, ideally without slowing economic activity. (13)

And since higher interest rates mean more competition for investment dollars and lower corporate earnings, stock markets don’t tend to react favorably, especially when 3-4 interest rate cuts were expected earlier this year.

The Fed issues its next interest rate decision on Wednesday afternoon, May 1, 2024. No change in interest rates is all but a given. However, what Federal Reserve Chairman Jerome Powell says about the recent economic data and the Fed’s stance on when future rate cuts are coming will no doubt be parsed word for word for clues when the press conference is convened.

Please pass the popcorn.

If you would like to review your current investment portfolio or discuss any other retirement, tax, or financial planning matters, please don’t hesitate to contact us at 734-447-5305 or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client, an initial consultation is complimentary, and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client and your financial plan and investment objectives are different.

Footnotes:

 1, 3, 8–9, 11) U.S. Bureau of Labor Statistics, 2024

 2)The New York Times, April 10, 2024

4) Federal Reserve, 2023

5) Forbes, December 5, 2023

6) The Wall Street Journal, April 15, 2024

7, 12) U.S. Bureau of Economic Analysis, 2024

10) NPR, April 18, 2024

13) Bloomberg, April 19, 2024

What’s Going on in the Markets November 29, 2023

Who ya’ gonna believe? The headlines or the market?

The latest economic headlines read:

“Credit Card Defaults are on the rise”
“Household savings rates are at historic lows”
“Banking Credit Contracts to Levels Not Seen Since the Global Financial Crisis”
“Home Builder Confidence from the National Association of Homebuilders takes another sharp drop”
“Trucking Employment is Contracting at a rate not seen since the 2000 and 2008 Crises.”
“The Conference Board of Leading Economic Indicators Declined for the 19th consecutive month”
“Yield Curves are Steepening after being extensively inverted, a sign of recession”
“Overdue commercial property loans hit 10-year high at US banks”
“No End in Sight for the Ukraine-Russia War”
“Could The War in the Middle East be the start of World War 3?”
“World Panics as supply of Twinkies Shrinks” (OK I made that one up to see if you’re paying attention)

With headlines like these, you’d think the stock markets were crashing, and we’re already in a deep recession.

Instead, the markets are having one of their best Novembers in history (after an awful October), which has led to headlines like these:

“The stock market is following a rare pattern that could signal double-digit gains next year”
“Extreme investor bearishness suggests stock market gains of 16% are coming in the next 12 months”
“The S&P 500 could soar more than 20% in the next year after an ultra-rare buy signal just flashed”
“This stock market signal points to the S&P 500 surging 25% within the next year”
“The Dow just flashed a bullish 'golden cross' Two days after the bearish 'death cross' signal”

High inflation and interest rates, two prominent wars, and unprecedented dichotomies continue to mount throughout the market and the economy, which can only mean that Wall Street’s roller-coaster ride is far from over. Let’s take a closer look at some of the headlines driving the markets.

Leading Economic Indicators

The Conference Board’s Leading Economic Indicator (LEI) has warned of trouble all year. It has declined for 19 consecutive months, its third-longest streak on record. When viewed as a ratio with the Conference Board’s Coincident Economic Indicator (CEI), declines from peaks have typically led to recessions. When decreasing, this ratio provides evidence that coincident indicators are holding up, but leading indicators are deteriorating. The Leading-to-Coincident Ratio has steeply declined since its peak in December 2021. Never has this ratio fallen this far and at such a rapid rate without a corresponding recession.

Treasury Yields

Another warning sign still flashing red and has a near-perfect track record for predicting recessions is the yield spread between 10-year and 2-year Treasurys.

Typically, one would expect to receive a higher interest rate on longer-duration bonds, CDs, debt, etc. After all, the more time a debt is outstanding, the more risk the lender takes (e.g., default risk, interest rate risk, bankruptcy, death, etc.). 10-year Treasurys should normally pay a higher interest rate than 2-year Treasurys to compensate lenders (the public) for this added risk.

An inversion means shorter-duration Treasurys command a higher interest rate than longer-duration Treasurys. Historically, inversions are unusual and indicate the economy is vulnerable. After all, if you’re concerned about the economy, it means you’re concerned about corporations being able to pay back their debt. Hence, you’re more likely to buy shorter-term debt. That pushes shorter-term interest rates into inversion. Simply put, if you had concerns about your brother-in-law paying back a personal loan, you’re more likely to keep the term shorter rather than longer, right?

The most recent inversion of the 10-year treasury bill and the 2-year treasury bill interest rates began in July of 2022 and quickly became its deepest (widest) since the early 1980s. The initial inversion is an early warning sign of a potential oncoming recession, but when this yield spread moves back above 0.0 (or it un-inverts), historically, there are four months on average before the onset of a recession. So, this is another definite recession warning sign.

Institute for Supply Management (ISM) Economic Indicators

A few macroeconomic indicators bounced back from dire levels or improved earlier this year, spurring hopes of a soft landing. However, unfortunately, many of these improvements have recently reversed course.

The ISM manufacturing index, also known as the purchasing managers' index (PMI), is a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It is a key indicator of the state of the U.S. economy. The PMI measures the change in production levels across the U.S. economy from month to month. The PMI report is released on the first business day of each month.

The 50 level in the PMI (both manufacturing and services) is the demarcation between economic expansion and contraction. Above 50, it’s expanding; below 50, it’s contracting.

Late last year, the ISM Manufacturing PMI index fell into contraction territory (<50.0) and has yet to move back into expansion. It has contracted for 12 consecutive months, showing some improvement mid-year before dropping once again in October.

The ISM Non-Manufacturing (or services) Index is an economic index based on surveys of more than 400 non-manufacturing (or services) firms' purchasing and supply executives. The ISM Services PMI comes out in the first week of each month and provides a detailed view of the U.S. economy from a non-manufacturing standpoint.

The ISM Services Index has been resilient this year, dropping below 50.0 just once since the pandemic. After initially improving in early 2023, it has declined for the past two months and is now at a five-month low. Because more than 70% of the economy is services-based, any contraction would not benefit the whole economy.

Housing and Real Estate

Housing, another major economic sector, accounts for 15-18% of U.S. GDP and is also on somewhat of a roller coaster ride of its own. Despite its improvement earlier this year, home sales have retracted and are at their lowest levels since 2010.

Existing home sales, which comprise most of the housing market, decreased 4.1% in October 2023 from the level in September to a seasonally adjusted annual rate of 3.79 million, the lowest rate since August 2010, according to the National Association of Realtors. October sales fell 14.6% from a year earlier.

New home sales for October came in lower than expected at 679,000, lower than September’s surprise of 759,000 but slightly higher than August’s 675,000. Despite being below expectations, these numbers are pretty robust (not surprising, given that existing homeowners with low mortgage rates are not selling).

Today’s housing market is still one of the most unaffordable in U.S. history. Home prices have exceeded the extremes of the 2005 housing bubble peak. With today’s high mortgage rates, high home prices, and ever-increasing ownership costs, housing activity seems to be at a standstill overall. Continued declines in home sales would hint at a bursting housing bubble.

On November 8, the Financial Times reported that overdue commercial property loans hit a 10-year high at U.S. banks. The Federal Reserve’s hiking campaign to curb inflation has caused borrowing costs of all types to surge this year, including in commercial real estate. Combined with empty building space from the pandemic work-from-home trend, commercial real estate is in a tight spot. The Green Street Commercial Property Price Index is now down nearly 20% from its 2022 peak and back to a level not seen since the short COVID-induced recession in 2020.

Inflation

While commercial property prices have fallen, price pressures elsewhere have reaccelerated in recent months, prompting consumers to expect inflation to remain elevated in the months ahead. After all, how many items at the grocery or department store have you seen come down in price (besides perhaps eggs and gasoline?)

For October, while headline and Core Consumer Price Indexes (CPI) improved slightly (inflation down), the recent acceleration in consumer inflation expectations indicates that this improvement could be temporary.

In consumer sentiment surveys, the first half of this year saw consumers growing more optimistic about the economy as inflation slowed; however, expectations of future inflation have surged since then, and consumers are becoming discouraged again. Discouraged consumers turn into non-confident consumers who tend to put away their wallets and walk away from discretionary purchases.

Since September, consumer expectations of higher inflation in 12 months have increased significantly to 4.4%. Meanwhile, inflation expectations in five years reached 3.2% as of October’s interim report, their highest level in over a decade. Despite the recent easing in the CPI data, this inflationary expectation pressures the Federal Reserve to keep interest rates elevated.

Inflation expectations notwithstanding, consumers have enthusiastically supported the economy this year despite inflationary challenges. However, the upward trend in credit card delinquency rates indicates an increasingly stressed consumer. Figures from the Federal Reserve show that credit card delinquencies have risen to 2011 levels, and delinquent auto loans are at their highest since 2010. Though not at the extreme levels seen during the Great Financial Crisis (2007-2009), these delinquencies are not slowing and could quickly surge higher if stronger parts of the economy begin to falter.

Jobs

Employment continues to be the last bastion of strength in today’s economy and is important to watch. Jobs remain plentiful, and employees increasingly view employment as transactional (as opposed to long-term). While the unemployment rate remains at historic lows, it has trended upward recently, which could become worrisome.

The unemployment rate in October clocked in at 3.9%, quite low by historical standards but 0.5 percentage points higher than the low rate we saw earlier this year (3.4%).  Increases in the unemployment rate of at least 0.6 percentage points from a cyclical low have confirmed the onset of nearly every recession of the past 50 years, with only one false signal in 1959. Accordingly, the unemployment rate is now just 0.1 percentage points away from reaching this threshold, which would confirm the onset of a recession. The November monthly jobs report and the unemployment rate are scheduled to be released on Friday, December 8.

The Stock Markets: What? Me Worry?

Since the start of November, the S&P 500 Index has been up about 8.5%. The tech-heavy NASDAQ index is up about 10.8%.

Rocket-boosted by the Magnificent Seven tech stocks (Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla), the indexes would not be anywhere nearly as strong without them. While the combined seven stocks are up about 80% year-to-date, the other 493 stocks in the S&P 500 Index are flat. While historically, a handful of stocks “carry” the indexes, we usually see better performance from the rest, and we’re largely not seeing that. Lately, the rally is showing signs of slowly broadening out, which is a good sign going into year's end.

If you look at the S&P 500 Index on an equal-weight basis (where each stock has an equal “vote,” as opposed to a weighted approach based on company size), the index would be up only 3.8% year-to-date. The Mid-cap 400 index is also up 3.8% year-to-date, and the Small Cap 600 is up 3.3%.

Since we’re in the 4^th quarter of a pre-election year, the markets have two reasons to be seasonally positive. True to form, November has reclaimed most of the losses from August to October and looks poised to take out the July high in December. As long as the S&P 500 Index holds the 4400 level, things look good. Daily new high prices among stocks that outnumber new low prices are also encouraging and add to the rally's strength.

My main concern is with the valuation of the Magnificent Seven Stocks. Compared with the Nifty Fifty Stocks in 1972 and the Tech bubble in 2000, these seven stocks are just as overvalued. Momentum trading combined with valuations this extreme can turn great companies into terrible investments, so buyers at these levels should beware. Should the drive to buy anything related to AI (Artificial Intelligence) cool off in 2024, these seven stocks will have a disproportionate effect on the indexes, driving down the markets quickly, especially since so many portfolio managers have piled into them as “safe havens.” I’m not saying to sell them now, but if you’re overexposed to them and have enjoyed the ride, it would be prudent to trim them at their current levels (this is not a recommendation to buy or sell.)

Recession Watch

A strong consumer, robust labor market, the housing wealth effect, and the lasting effects of a zero interest rate policy held in place too long have made 2023 recession callers look foolish (including me).

Underestimating the U.S. Consumer has always been a bad bet, especially when locked down for months, saving their stimulus checks and unspent wages and ultimately coming out of the gates splurging. While their savings are nearly depleted, I would not completely count them out just yet, and a recession in 2024 is definitely not a sure thing, although I still believe we will have one next year.

As discussed above, there are signs that the post-pandemic fiscal and monetary drugs are starting to wear off for the world’s economies, and a hangover might be on the horizon. Whether and when that hangover turns gross domestic product in a negative direction and, therefore, an economic recession, is anyone’s guess. I like what Bloomberg Points of Return writer John Authers wrote this week on that topic:

“…Having got this far, there’s now a pretty good chance the US can get through the next two years without a recession. But the odds still point more to a downturn. That explains the negativity in opinion polls and surveys of consumers, even if it completely fails to explain the enthusiasm among consumers when they go shopping. And then there’s the issue of stock market sentiment, which is utterly baffling.”

It would be understandable to read this post and think that things look grim and that it's time to batten down the hatches and sell everything. It's not. When it comes to discounting the future, the markets usually have it right (looking out 6-9 months), and we may just be experiencing some economic indigestion that will resolve itself, and the stock markets will challenge and exceed the all-time highs in 2024.

Election years are positive for a reason: the incumbents want to be re-elected, so you can't underestimate the levers they can pull to keep the economy firing on all cylinders and postpone any recession until a later year. Never underestimate what determined politicians can do.

What’s Going on in the Markets October 31, 2023

With so many global crosscurrents--another Middle East war, an uneven economy, stubborn inflation, and high interest rates, it’s no surprise that many will be happy to forget about October 2023. While nothing weighs as heavily as the horrific tragedies of the war in the Middle East, the stock markets saw their third consecutive down month after a terrific run up from the October 2022 bottom. Let’s look at what's weighing on the markets and what might be ahead.

Stubborn Inflation

Over the past year, I’ve expected inflation to retreat from its historically high level. But I've also stated in past writings that inflation pressures would be more stubborn than many on Wall Street believed.

After easing to 3.0%, the Consumer Price Index (CPI) has increased for three consecutive months and is now at 3.7%. Furthermore, measures of underlying inflation have started to reaccelerate.

In the latest Personal Income and Outlays reports, inflation showed an unwillingness to continue its recent descent. On Friday, October 27, the Personal Consumption Expenditures (PCE) for September showed inflation up 0.3% monthly (3.7% annualized). The PCE is the Federal Reserve’s (AKA The Fed) preferred measure of inflation.

While both inflation numbers are much improved over the 5%+ rates we saw earlier this year and last, they are a far cry from the Federal Reserve’s 2% annual inflation target.

Sticky Price CPI, which measures prices that are slower to change, like medical care, education, and housing, has resumed its increase. The annualized 3-month rate of change has shot up from 3.4% in July to over 4.4% last month. This is one of its highest readings of the past three decades outside of the post-pandemic surge. This suggests The Fed may have trouble getting inflation back to its 2% target.

Inflation measures are important not only because they erode the buying power of our dollars but also because they affect consumer sentiment, and sentiment influences consumer spending. Unhappy or non-confident consumers spend less, and less consumer spending can lead to an economic recession (which does not help keep stock prices up.)

High Interest Rates

To control inflation, The Fed adjusts short-term interest rates to cool consumer and business spending. The thinking is that higher interest rates discourage borrowing, which leads to lower demand, and lower demand presumably tends to portend lower prices.

The Federal Reserve meets about every six weeks to decide whether it will raise, lower, or hold short-term interest rates, considering various economic reports and factors. The last time they met was in September when they held short-term interest rates at 5.0%-5.25%.

In a meeting that concludes on Wednesday, November 1, they are widely expected to continue holding rates at this level. Many will listen to Federal Reserve Chairman Jerome Powell’s comments to assess the prospect of future higher or lower short-term interest rates. I think they’re done hiking rates but won’t hint at any rate reductions, which Wall Street is looking for.

The good news is that higher interest rates mean that cash is no longer “trash.” You can earn a 4.5%-5.5%+ return on your money market savings, CDs, and bonds. The bad news is that higher interest rates mean lower bond prices and may lead to an unprecedented 3^rd consecutive year of bond price declines (interest rates and bond prices are inversely correlated). In addition, higher interest rates on cash and bonds mean less of an urgency to take risks in the stock market, especially if one can get 5%-6% risk-free (no doubt that this sentiment has contributed to the pullback in the stock market over the last few months.)

Faltering Housing

Housing is one of the largest sources of wealth for consumers and a vital industry for the economy's health.

New Home Sales increased in September as homebuilders offered price-cut incentives and mortgage rate buydowns to attract buyers. Pending Home Sales, which tracks unclosed transactions of existing homes, ticked up in September but remained at the third lowest reading in its history.

Like consumer and business sentiment, homebuilder confidence is a crucial indicator to follow. It takes the pulse of current attitudes and can be an excellent predictor of future housing activity. Despite its rebound in the first half of the year, the National Association of Home Builders (NAHB) Housing Market Index (Builder Confidence Survey) is again falling. Today's low confidence levels indicate a much weaker outlook and reflect the effects of rapidly rising interest rates.

Today’s mortgage rates are at a 23-year high and heading toward 8.0%. This is a staggering increase of almost five percentage points since its record low in early 2021 and the second-quickest rise in history. The only faster increase in mortgage rates occurred in the early 1980s – a move only marginally steeper than today’s. Predictably, this has a significant impact on housing affordability.

Current multi-decade-high mortgage rates would be much more digestible to homebuyers if home prices weren’t still in a bubble. Unfortunately for them, prices have hardly budged. Home prices have surged by nearly 60% over the past five years, putting a significant strain on affordability. This problem has been exacerbated by rising mortgage rates, causing the average mortgage payment to increase by 134% since early 2018. And this doesn’t even include the increases in property taxes, insurance, repairs, maintenance, dues, etc. As a result, this is perhaps the most unaffordable time in U.S. history to buy a home.

Cooling Sentiment

Consumer and Business Sentiments are crucial to watch as their recent rebounds seem to be running out of steam. As mentioned above, consumer sentiment is essential to encourage spending and keep the economy “humming.” Small business sentiment is important because it encourages hiring, capital investments, and expansion. There are several surveys and measures of consumer and business sentiment, including widely followed surveys by the Conference Board and the University of Michigan.

October’s preliminary consumer sentiment readings plunged by more than forecast and were well below their 70-year average. Both Current Conditions and Future Expectations were down significantly. Inflation Expectations for the year ahead rose by 0.6 percentage points while expected business conditions for the next year dropped by 19%.

The latest and final October consumer sentiment readings from the University of Michigan finished October at 0.8 points higher than its preliminary reading yet is 4.1 points below September’s final reading. A significant reason for the decline in Consumer Sentiment this month was a rebound in consumers’ inflation expectations for the year ahead, which jumped from 3.2% to 4.2%.

The National Federation of Independent Businesses (NFIB) Small Business Optimism Index has been below its 49-year average for the last 21 months. Among small business owners, significant concerns remain regarding inflation, labor availability, and future economic conditions. As small businesses often need capital to grow, they are the most affected by high interest rates, and it is no surprise they are worried about the future.

I’m concerned about business and consumer sentiment because the readings I’m seeing have rarely occurred outside of an oncoming recession. Business owners are struggling, and there are signs that strong consumers are starting to tighten their belts.

Another Middle East War

As the horrific events in the Middle East continue to develop and command the attention of the world, economic issues may seem relatively unimportant. However, the Israel-Hamas conflict creates geopolitical risks with potential global economic consequences, and it may be helpful to consider early projections and analysis of how these consequences might unfold.

Any impact comes when the global economy is fragile, already strained by the ongoing Ukraine-Russia war, and facing challenges such as weak growth, economic fragmentation, high interest rates, and stubborn inflation.

On the other hand, the U.S. economy appears relatively strong by many measures, and the United States is the world's largest oil producer and thus relatively insulated from small shifts in the global oil supply that usually occur during wartime.

While U.S. military support of Israel will add to expenditures that have already been increased by the Ukraine war, U.S. Treasury Secretary Janet Yellen has indicated that the United States can support both allies. Of course, that will lead to even more inflation, causing spending deficits.

Many U.S. technology companies have production or research and development facilities in Israel. However, work in those facilities is expected to continue except for employees called for reserve duty.

So far, the U.S. stock market reaction to the war has been relatively muted. Historically, wars outside U.S. borders tend not to create lasting trouble for the domestic stock market.

Clearly, it is still early, and the economic situation can change anytime. For now, while the Israel-Hamas conflict is a tragic humanitarian crisis, it is not a reason to change your personal financial or investing strategy.

Wobbling Stock Markets

October has been living up to its reputation for being a volatile month in the stock markets and closing down for the third consecutive month (-2.2%). The S&P 500 index is down over 9% from the peak in July 2023. However, we are entering a seasonally favorable time of year in the markets. November to December tend to be stronger months of the year, but as a pre-election year, it has even more favorable seasonality. Finally, when the market is so strong as it was through July, historically, it has also portended a nice finish to the year.

But given the headwinds just discussed, any year-end rally could fail to meet expectations or, worse, not materialize.

There is a continuing debate about whether the October 2022 lows ended the bear (down trending) market that started in January 2022. Some assert that a new bull (up-trending) market was born and that we are in the early innings of an upward trend, the start of a new bull market. Others assert that the bear market is intact, and all that we’ve witnessed since October 2022 was an extended bear market rally, which is now over. Only in the fullness of time can we know which camp is right.

The bears will point out that it is unprecedented to have a 10% correction in the first year of a bull market. It’s also unusual to see small capitalization stocks struggle so much in the early stages of a new bull market. In fact, the small caps are down for the year and are at risk of undercutting their October 2022 lows. Thus, the outsized correction and narrowness of the rally from the October 2022 bottom gives me food for thought and leaves me a bit skeptical that we’re in a new bull market.

Currently, on the surface, the S&P 500 is up about 9.2% year to date. But if you take away the seven strongest tech stocks in the index, AKA the Magnificent Seven (Apple, Amazon, Meta, Microsoft, Microsoft, Nvidia, Tesla), the index would be only up slightly on the year. In fact, if you look at the equal-weighted S&P 500 index (where each stock gets an equal “vote” rather than being weighted by size), it is down 4.1% year-to-date. Clearly, most stocks are not participating in the “new bull market."

By all accounts, so far, third quarter 2023 corporate earnings are strong and beating expectations, though revenue growth is somewhat tepid. Much of the earnings growth comes from higher profit margins, meaning that cost savings are the primary driver of higher earnings, not strong and improving consumer demand.

Until seasonality asserts itself and strength re-emerges in the stock market, I believe caution and defensiveness are warranted for short-term investors. For long-term investors, this may be a time to pick some favorite positions you plan to keep for 3-5 years or longer. While this is not a recommendation to buy or sell any securities, this is when taking advantage of a stock market sale works in the long term. For our client portfolios, we remain hedged and recently slightly reduced our exposure to stocks, considering the risks discussed above.

Recession or No Recession?

When it comes to economic recessions, it’s a matter of when not if. So, while pundits continue to debate whether we’ll have a soft landing (no recession) or a hard landing (recession), they both might be right—just at different times.

The last recession we had in 2020, post-COVID, was short-lived thanks to the extraordinary fiscal and monetary stimulus unleashed on the economy back then. This, in my opinion, has contributed to the inflation hangover we’re now experiencing. Pass the aspirin, please!

In my opinion, despite a still strong job market and robust consumer spending to date, the weight of evidence points to several areas of gradual deterioration in the economy that will lead to a recession by mid-2024. Admittedly, I thought we’d be in a recession with much lower housing prices by now. But I obviously underestimated the strength and durability of the consumer with wallets full of cash and credit cards looking to spend after an awful and extended COVID lockdown. And I clearly did not anticipate how fast mortgage interest rates would rise, taking existing homeowners with low-interest-rate mortgages out of the housing market and making the supply of homes as tight as it is.

Today, we have a federal reserve intent on taming inflation, so interest rates will be higher for longer, which is not stock-market friendly. While many might not dump their existing stocks in this new high-interest rate environment, they might not be as willing to take on more risk in a world where 5%-6% returns come “risk-free.” And while a stock market buyer's strike might not be as bad as all-out selling, it certainly doesn't help stock prices rise to the level of a new bull market.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so are your financial plan and investment objectives.

Source: InvesTech Research

Should the Government Shut Up or Shut Down?

As September ends, the U.S. government seems headed for a shutdown, which would begin on October 1st. Although it is possible that a last-minute agreement could keep the lights on, that becomes less likely with each passing day. With all the nonsense that comes from Washington, would we rather have our government shut up rather than shut down?

Regardless, here's a look at the federal funding process, the current situation in Congress, and the potential consequences of a failure to fund government operations.

Twelve appropriations bills

The federal fiscal year begins on October 1, and under normal procedures, 12 appropriations bills for various government sectors should be passed by that date to fund activities ranging from defense and national park operations to food safety and salaries for federal employees.

These appropriations are considered discretionary spending, meaning that Congress has flexibility in setting the amounts.  Although discretionary spending is an ongoing source of conflict, it accounted for only 27% of federal spending in fiscal year (FY) 2023, and almost half of that was for defense, which is typically less of a point of conflict. Mandatory spending (including Social Security and Medicare), which is required by law, accounted for about 63%, and interest on the federal debt accounted for 10%.(1)

Obviously, it would be helpful for federal agencies to know their operating budgets in advance of the fiscal year, but all 12 appropriations bills have not been passed before October 1 since FY 1997. In 11 of the last 13 years, lawmakers have not passed a single spending bill in time.(2) That is the situation as of September 27 this year (although, one bill, to fund military construction and the Department of Veterans Affairs, has been passed by the House but not the Senate.)(3)

Continuing resolutions and omnibus spending bills

To buy time for further budget negotiations, Congress typically passes a continuing resolution, which extends federal spending to a specific date, generally at or based on the same level as the previous year. These bills are essentially placeholders that keep the government open until full-year spending legislation is enacted. Since 1998, it has taken an average of almost four months after the beginning of the fiscal year for that year's final spending bill to become law.(4)

Even with the extension provided by continuing resolutions, Congress seldom passes the 12 appropriations bills. Instead, they are often combined into massive omnibus spending bills that may include other provisions that do not affect funding.  For example, the SECURE 2.0 Act, which fundamentally changed the retirement savings rules, was included in the omnibus spending bill for FY 2023, passed in late December 2023, almost three months into the fiscal year.

Current Congressional situation

The U.S. Constitution gives the House of Representatives sole power to initiate revenue bills, so the House typically passes funding legislation and sends it to the Senate. There are often conflicts between the two bodies, especially when they are controlled by different parties, as they are now. These conflicts are typically settled through negotiations after a continuing resolution extends the budget process.

In a reversal of the typical process, the Senate acted first this year, releasing bipartisan legislation on September 26 that would maintain current funding through November 17 and provide additional funding for disaster relief and the war in Ukraine. Although this is likely to pass the Senate later in the week, it was unclear how the House would react to the legislation.(5)

Late on September 26, the House cleared four appropriation bills for debate (Agriculture, Defense, Homeland Security, and State Department). It is unknown whether these bills will pass the House, and if they do, it will likely be too late to negotiate the provisions with the Senate. A proposed continuing resolution that would extend government funding and include new provisions for border security had not been cleared for debate as of the afternoon of September 27.(6)

Effects of a shutdown

The effects of a government shutdown depend on its length, and fortunately, most are short. There have been 20 shutdowns since the current budget process began in the mid-1970s, with an average length of eight days. The longest by far was the most recent shutdown, which lasted 35 days in December 2018 and January 2019, and demonstrates some potential consequences of an extended closure.(7) However, in 2018-19, five of the 12 spending bills had already passed before the shutdown — including large agencies like Defense, Education, and Health & Human Services — which helped limit the damage. The current impasse, with no appropriations passed, could lead to an even more painful situation.(8)

Here are some things that will not be affected: The mail will be delivered. Social Security checks will be mailed. Interest on U.S. Treasury bonds will be paid.(9) However, some programs will stop immediately, including the Supplemental Nutrition Program for Women, Infants, and Children, which helps to provide food for about seven-million low-income mothers and children.(10)

Federal workers will not be paid. Workers considered "essential" will be required to work without pay, while others will be furloughed.  Lost wages will be reimbursed after funding is approved, but this does not help lower-paid employees who may be living paycheck to paycheck.(11) In an extended shutdown, the greatest hardship would fall on lower-paid essential workers, which would include many military families. Furloughed workers would struggle as well, but they might look for other jobs, and in many states would be able to apply for unemployment benefits.(12) Members of Congress, who are paid out of a permanent appropriation that does need renewal, would continue to be paid (shocked, aren’t you?).(1)3

Air travel could be affected. In 2019, absenteeism more than tripled among Transportation Security Administration (TSA) workers, resulting in long lines, delays, and gate closures at some airports. According to the TSA, many workers took time off for financial reasons.(14) Air traffic controllers, who are better paid, remained on the job without pay and without normal support staff. However, on January 25, 2019, an increase in absences by controllers temporarily shut down New York's La Guardia airport and led to substantial delays at airports in Newark, Philadelphia, and Atlanta. This may have been the impetus to reopen the government later that day.(15)

Unlike federal employees, workers for government contractors are not guaranteed to be paid, and contractors often work side-by-side with federal employees in government agencies. In 2019, it was estimated that 1.2 million contract employees faced lost or delayed revenue of more than $200 million per day.(16) A more widespread shutdown would put even more workers at risk.

While essential workers will maintain some federal services, furloughed workers would leave significant gaps. At this time, it's unknown exactly how each agency will respond to a shutdown. In 2019, some national parks used alternate funding to maintain limited access, which caused problems with trash and vandalism and was deemed illegal by the Government Accounting Office. This year, all parks might be closed during an extended shutdown.(17) Many other federal services may be delayed or suspended, ranging from food inspections to small business loans and economic reports.(18) Delays in economic statistics could make it more difficult for the Federal Reserve to judge appropriate monetary policy.(19)

Although a shutdown would cause temporary hardship for workers and the citizens they serve, the long-term effect on the economy would be relatively benign, because lost payments are generally made up after spending is authorized. A shutdown might decrease gross domestic product (GDP) for the fourth quarter of 2023, but if the shutdown ends by the end of the year, GDP for the first quarter of 2024 would theoretically be increased. Even if delayed spending is recovered, however, lost productivity by furloughed workers will not be regained. And an extended shutdown could harm consumer and investor sentiment.(20)

Surprisingly, previous shutdowns generally have not hurt the broad stock market, other than short-term reactions. But the current market situation is delicate to begin with, and it is impossible to predict future market direction.21

For now, it's wise to maintain a steady course in your own finances. Based on historical precedent, the shutdown is a non-event as far as your investment portfolio is concerned. But in the event of a shutdown, be sure to check the status of federal agencies and services that may affect you directly.

And the next time you see your favorite federal government politician, let them know you’d prefer them to shut up rather than shut down.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so are your financial plan and investment objectives.

Sources:

1) Congressional Budget Office, May 2023
2, 4, 8) Pew Research Center, September 13, 2023
3) Committee for a Responsible Federal Budget, September 27, 2023
5, 6, 9, 18, 19) The Wall Street Journal, September 26, 2023
7, 11) CNN, September 21, 2023
10) MarketWatch, September 26, 2023
12) afge.org, September 25, 2023 (American Federation of Government Employees)
13) CBS News, September 25, 2023
14) Associated Press, January 21, 2019
15) The Washington Post, January 25, 2019
16) Bloomberg, January 17, 2019
17) Bloomberg Government, September 12, 2023
20) Congressional Research Service, September 22, 2023
21) USA Today, September 26, 2023