Cash could come in handy soon

Over the weekend, central bankers from the world's major economies gathered for their annual conference in Jackson Hole, USA, but there was no clear signal on the future direction of policy rates. Among the Western central banks, the Fed and the ECB move in line with developments in inflation and economic data. And so far, this data has given little hope of an easing of policy rates.

This week on Thursday there will be more data on price developments in Europe and the US.

In this post, we talk about how interest rate hikes seem to be peaking in Europe for now. That would be pretty great news for homeowners. Then we move on to the US, the world's largest economy, where I have found more weakness. Cash could still be put to good use in falling stocks.

Eurozone interest rate hikes at peak

Now that the dust has settled on weak purchasing managers' indices in the eurozone, we can see how the latest data has been reflected in interest rates. On Friday, we found out that German GDP stagnated, i.e., grew (or failed to grow) by 0% in the second quarter compared with the first quarter. GDP data is inaccurate at first and backward-looking, but the country is effectively on the brink of recession. However, with inflation hovering around 6%, the economy is still growing at an annual rate of more than 6% in nominal terms. Prices are going up, but real welfare will remain unchanged.

With this news, market expectations of ECB rate hikes have moderated relative to early August. The policy rate will therefore remain at the current level of 3.75%-4.5%, depending on which of the three ECB rates you are looking at. In a year's time, the market expects that the policy rate will already be a notch lower. Expectations are always expectations, and in practice the ECB's moves are determined by inflation, which remains awkwardly persistent.

 

Interest rate movements are certainly of interest to Finnish homeowners, as Euribor and policy rates move hand in hand. The current rise has been historically steep, but with the economy crumbling, interest rates can hardly afford to rise further (*knocks on wood*).

Economic slowdown not reflected in US equities and interest rates

I mentioned in my latest post how the weakening borrowing among US households could throw a spanner in the works of the red-hot economy. To summarize the point that I made: many investors have been anxiously waiting for a recession and falling interest rates in the US, but so far the US economy has been red-hot. Naturally, it also keeps inflation, and therefore interest rates, high.
However, I would like to challenge the talk about the expecting a recession in the market in general in the sense that there is no hint of expecting a recession in stock prices.

The economy has been kept particularly strong by strong employment and wage growth, fueling consumer demand. This deterioration in the credit data may be a symptom of a soon weakening demand.

Neither the labor market nor strong wage growth show signs of cracking yet, but there is anecdotal evidence of cooling. According to the Wall Street Journal, wage levels for new jobs have started to fall. During the pandemic, wages ran rampart as companies tore the unemployed off their couches and lured them into work with fat stacks. But as the economy cools down, the need to recruit decreases, and now job offers are thinner. In some sectors, starting wages have fallen by up to 20% in a year. As new jobs represent only 4% of all jobs monthly, this cooling will take time to show up in the official data.

There are still almost 10 million vacancies in the country, despite the downward trend. It's worth mentioning that recently, the previously strong job data has started to be adjusted downwards, after a closer look at the papers.

Recent purchasing managers' index data also support this story. According to data compiled by S&P Global, growth in the US services sector is stalling and manufacturing has been in decline for some time. The services sector is the larger of the two and sets the pace of the economy.

What is interesting about this industrial weakness is that the stock prices of large industrial companies are practically at their all-time highs. The S&P 500 industrial index and the ISM industrial purchasing managers index are juxtaposed in this graph. While the PMI has been flatlining in the doldrums below 50, equities have recovered from the fall lows to new highs.

Of course, it may be the case that large listed industrial companies do better in difficult times, while smaller ones suffer and therefore respond more modestly to these inquiries. The everyday life of major listed companies does not match that of the average small company in the real economy. It’s always good to bear this in mind, as the daily life of the stock market is not the same as the rest of the real economy. But many large industrial companies from Fastenal to Rockwell Automation have seen their growth slow or cut their guidance for the current year. In this sense, the direction of stock prices and the development seen by companies seem contradictory.

Instead of trying to guess the future direction of stock prices by gauging the macroeconomy, one can flip the situation around and look at stock prices as the best economic indicator. If equity investors are right, the industry will recover soon.

Adding to the confusion is industrial construction investment in the US, which is at a record high of almost EUR 200 billion a year. The mega-investments are mainly in the computer, electronics, and electrical industries. If the outlook were bleak, companies would be unlikely to invest like no tomorrow. On the other hand, if there really is a recession, the classic signs of over-investment are in the air.

When thinking about the inner workings of the economy, let's not forget that a couple of years ago we had a massive global pandemic which completely disrupted the industrial value chain. First inventories were firesold in a panic, then they were filled in a hurry and then they were unloaded again. The messy wake of these is still mudding the waters.

Secondly, and I think this is the most important point, the US federal government is running massive budget deficits, which are usually only seen in times of crisis. Trump's tax cuts and Biden's investment boost the economy. During the pandemic, politicians did not want to repeat the mistake of the financial crisis of under-stimulating. Now it’s the other way around. The budget deficit is about $1.6 trillion a year, or 6% of the GDP. And this is how things are expected to be for the next ten years. This has never been experienced in peacetime. In practice, the economy is like that of wartime. A stimulative economic policy feeds inflation and pushes up interest rates. The economic growth cycle can live much longer than normal. We are amid a virtually unprecedented investment boom to fix the US' outdated infrastructure and tackle climate change. Such an environment does not exactly anticipate a recession. We are indeed living in the roaring 20s.

 

Thus, the weaker economic news of recent days has been moderately reflected in market interest rates. The US 10-year rate has hovered around 4.2%.

However, expectations of a Fed rate hike have cooled down somewhat. In another couple of years, the Fed policy rate would be almost 4%.

The Atlanta Fed's GDP Now gauge now forecasts as much as 6% GDP growth for the third quarter, so right this second the economy is nowhere near a recession.

But as an investor, it's worth looking further afield. What will the world look like in the fall of 2024? Where can the red-hot US economy improve from here? If a recession does eventually come, will the US stock market be a very attractive place to be, as shares are priced quite generously based on inflated earnings forecasts, which in turn are based on record profit expectations. The S&P 500 earnings multiples are at levels seen mainly in the pandemic bubble and a few times in the 2000s in general. However, the S&P 500 does include super-companies such as Nvidia and Apple, which deserve higher multiples and their heavy weighting in the index raises the general valuation of the stock market.



If we look at the balanced version of the S&P 500, we get the valuation multiple of the average listed company. The forward-looking P/E ratio is less than 15x, which is not very high historically, although it is not a discount either given the interest rate environment.

We can’t predict something as complex as the economy. But in the spirit of Howard Marks, we can look at where we are going now and what the stock market already holds. The economic cycle is now at a mature stage. This could go on for years as I suspected, but it already seems to be in the share prices. On the other hand, a red-hot economy is not necessarily good for equities either, as it pushes interest rates higher and higher, which takes support away from equity valuations. There is no room for unexpected setbacks. And when those eventually come, investors should be ready to take advantage of the buying opportunities.

Like Inderes economist Marianne Palmu wrote a while ago in the Macro Review, after the financial crisis investors got used to an anemic economic environment where the public sector tightened its belt while central banks tried to get the economy going with zero interest rates and stimulus programs. Now the situation is quite the opposite, with the federal government, especially in the US, stepping on the gas while the Fed tries to put the brakes on the economy as much as it can.

Equities no longer have the safety cushion of a zero interest rate period. Fixed rate yields are competitive. If the economy is rattling, investors will no longer be attracted to the more expensive stocks.

It may be that the recession many are expecting will not arrive until the US starts to rebalance its public finances and tighten its belt. And if the US economy ends up in recession, it will be felt around the world. Then the European and Finnish equities that I praise may fall a notch more. All in all, cash could be put to work in the coming years.

Thank you for reading the post! Read analysis and make good stock picks!