Three Key Thoughts:

1. Jobs, Jobs and More Jobs

2. Rates Higher for Longer

3. Xiconomics

Jobs, Jobs and More Jobs

In 2021, annual inflation (CPI All Urban Consumers) rose from 1.40% in January to 7.04% at the end of the year. In 2022, inflation continued its march upward, heading toward a peak of 9.06% in June. Realizing that this steep rise in inflation was not actually “transitory,” the Federal Reserve embarked on a very aggressive campaign to raise short-term interest rates starting in March of 2022. This program took short-term rates from zero to 5.25% today, an historically steep and fast rise.

What are the results? Inflation has clearly come down -- the most recent report shows annual inflation at 4.05%. But the Fed has set a target of 2% annual inflation. To achieve that goal, there is general agreement that we will need to slow the economy and, particularly, employment and wage gains. That has been difficult to achieve at least partially because fiscal policy, i.e., government spending resulting from the Bipartisan Infrastructure Law and the ironically named Inflation Reduction Act, is working in the opposite direction.

So far in 2023, job gains have averaged nearly 275k per month, while average hourly earnings increases have been steady, averaging 4.4%. The unemployment rate has also stayed steady, averaging about 3.5% for the last twelve months. Finally, total job openings have come down from the historic levels of several months ago but are still more than 2 million above the pre-pandemic high.

All of this is to say that the job market remains tight and reasonably hot. As long as this remains true, the economy will likely continue to grow, inflation will stay above the Fed’s target and the Fed will continue to raise interest rates further.

Rates Higher for Longer

The mini banking crisis last quarter led many to believe that the Fed was done raising interest rates. Indeed, we made the case last quarter that the crisis was a direct result of the Fed’s interest rate hikes so it was easy to jump to a conclusion that, having caused a small crisis, they might pull back. The idea that rate hikes might be over brought optimism to the stock market, where a strong rally took hold in March and continued through the second quarter. That optimism was fueled further by the Fed not raising rates at its June meeting.

While we are likely getting close to the end of the Fed’s rate increases, we don’t think we are there quite yet. Instead, we expect that short-term interest rates will stay higher than both inflation and long-term rates for some time to come. This is a very unusual situation but so long as the labor market stays strong and wage pressures continue, then the Federal Reserve’s 2% target will likely remain elusive.

Interestingly, the strong labor market has not carried over into consumer sentiment. As measured by the University of Michigan, sentiment is roughly where it was in the depths of the financial crisis in 2008. Meanwhile, consumers’ actual financial position is quite strong, with debt levels relatively low and incomes consistent. We can speculate on why sentiment remains poor – pandemic overhang, inflation worries, political divisiveness, to name a few possibilities – but consumer spending has stayed very positive, keeping our economy growing.

Xiconomics

After nearly three years of Draconian lockdowns, there was a great deal of optimism regarding the “re-opening” of China’s economy once those COVID restrictions were eliminated last fall. That optimism has now turned to realism that the structural problems plaguing the Chinese economy (most importantly, the residential real estate crisis, lack of consumer confidence, regulatory overhang, a rapidly aging population, high youth unemployment) are very much still in place, post-COVID.

President Xi clearly understands the importance of a growing economy to the stability of the country. However, his views of how to achieve that growing economy are very different than his recent predecessors. Xi envisions a strong and growing role for State Owned Enterprises (SOEs) and a central role for the Chinese Communist Party (CCP) in planning the areas of growth emphasis. This defining role for the CCP is in sharp contrast to the central role played by private enterprise in the growth successes of the past three decades. It remains to be seen how well government-centric priorities can be executed. For example, creating technological independence is a key goal, i.e., developing advanced chip-making and software development capabilities to dramatically reduce China’s reliance on the West in these areas. Of course, in these efforts, China will run headlong into US efforts to limit China’s access to key US technologies.

More important than this struggle over technology independence are the issues facing China’s consumer economy. Problems in the real estate market followed COVID as some overleveraged developers could not finish pre-sold apartments, leading to mortgage delinquencies, reduced demand and falling prices. Despite assurances and targeted relief from policymakers, the real estate market remains in the doldrums. This is weighing heavily on consumer sentiment because a substantial portion of consumers’ net worth is tied to real estate. Very high youth unemployment (20%) adds further gloom to the consumer picture.

The historical record for authoritarian governments guiding their economies to growth with centralized policies has few, if any, successes. We remain skeptical that Xiconomics will be the exception.

Investment Implications

We continue to be cautious about the current environment, believing that there may be more downside to the economy and markets in the near term than upside. On the plus side, we can now earn a “real” return on short term fixed income investments, so we are favoring those over cash. We continue to focus on investing in stocks of companies that will thrive through and beyond the economic weakness that likely still lies ahead.