Chart showing total U.S. employees on non-farm payrolls from 2005 through 2022. After a sharp rebound in 2021 and 2022, job growth is expected to slow in 2023. If you are in need of the data behind this chart, please email BBHPrivateBanking@bbh.com.
This traditional January expression of good cheer and optimism is customarily followed by an enthusiastic and hopeful exclamation point, but given the challenges investors confronted last year, and the uncertainty with which we begin the new one, we thought it more appropriate and cautious to employ a question mark instead. At least for now.
We welcome the new year with three related questions:
In this article, we’ll consider the state of play as we embark on the 23rd year of this century and consider what it might take to edit our question mark into a period, if not the usual exclamation point, as the year progresses.
Soft or Squishy?
No one rings a bell to signal the end of a pandemic. Yet behaviorally, at least, COVID-19 seems to be drawing to a close. People are flying, restaurants are full, theaters and churches are open, and workers are slowly returning to offices. But the economic ripple effects of the pandemic recession and the fiscal and monetary stimulus imposed in 2020 and 2021 continue to reverberate. The Trump and Biden administrations spent over $5 trillion to prevent the pandemic recession from becoming something worse. It worked. According to the National Bureau of Economic Research, economic activity collapsed in February 2020 but bottomed a mere two months later in April 2020, marking the shortest recession since economic record-keeping began in 1854.
For all of its messiness, the U.S. economy prior to the pandemic was a reasonably well-tuned system. The pandemic and subsequent policy response knocked it off balance, as shown by wide swings in inventory building, external demand, supply chain reliability, labor availability, and so forth. As we return to some semblance of normality, the future path and pace of economic growth will depend on the primary engine of economic activity: consumer spending. Herein lies the economic challenge for 2023, and herein lies our focus.
We foresee multiple headwinds to consumer spending in 2023, starting with the labor market. The good news is that the labor market has recovered all of the ground lost in 2020, adding, on average, close to 400,000 jobs per month in 2022. The bad news is that this pace of growth is unsustainable. As the recovery phase comes to an end, future expansion will rely on organic growth, and our labor market simply doesn’t grow by hundreds of thousands of jobs per month. For the decade preceding the pandemic, monthly job growth averaged 183,000, which would mark a sharp deceleration from the current pace. To be clear, we do not expect job growth to evaporate, just slow down. The effect here is largely psychological: Even if job growth remains absolutely healthy, the relative slowdown in 2023 could weigh on consumer sentiment, and therefore spending.
The story is similar with housing. New housing starts fell by 40% during the pandemic, restricting supply at precisely the point where the demand for housing soared as buyers, flush with stimulus money, sought to take advantage of low mortgage rates and move into larger (or more suburban) homes. The average price of a house in the United States rose 53% from February 2020 through June 2022. These dynamics are now reversing. The supply of new houses has recovered, stimulus checks are a distant memory, and mortgage rates now hover around 7%. Not surprisingly, housing prices have softened, falling 10% from last summer’s peak. As with the labor market, the effect here may be mostly psychological. Even if a homeowner is not seeking to sell her home or refinance, the narrative of a weakening housing market makes her feel poorer, and, importantly, act poorer.
To be fair, there are plenty of things beyond labor and housing weighing on consumer sentiment. Take your pick: lingering high inflation, political dysfunctionality, a looming and likely debt ceiling crisis, continued Russian aggression in Ukraine, natural catastrophes, et cetera. It’s a target-rich environment for people looking for reasons to be nervous.
All of these moving parts can be succinctly captured in the aptly named Index of Leading Economic Indicators (LEI). As the title implies, this “meta index” comprises a variety of underlying indicators, including credit conditions, interest rate spreads, manufacturing sentiment, building permits, average work week, and initial claims for unemployment, all compiled to arrive at a real-time indicator of economic conditions. As the nearby graph illustrates, historically when the year-over-year change in the index dropped sharply, a recession almost always followed. We’re there now. The absolute index peaked in February 2022, turned negative as of June 2022, and now stands 7.4% lower than a year ago.
Chart showing the Index of Leading Economic Indicators from 1959 through 2022. The absolute index peaked in February 2022, turned negative as of June 2022, and now stands 7.4% lower than a year ago. If you are in need of the data behind this chart, please email BBHPrivateBanking@bbh.com.
The overwhelming evidence of an economic slowdown makes a recession forecast the majority view among most economists and forecasters. The far more interesting line of analysis is what shape a recession might take. Here, there is good news. Unlike previous cycles, there are no obvious financial bubbles that need bursting, and those smaller ones that have burst (crypto, anyone?) don’t seem to pose the systemic threat that housing and mortgage debt did in the last big recession. Furthermore, largely because of a decade and more of deleveraging, American households are in far better financial shape now than they were headed into the 2008 recession. Indeed, overwhelming household debt was precisely what made the Great Recession so great. This time is different.
Where it is true that household debt has risen to record highs, this observation on its own is incomplete. Just as an investor would never assess the financial strength of a company only by looking at outstanding debt, so, too, with households. The important measure is debt relative to something, usually assets or income. On these measures, American households are in decent shape, which should provide a cushion or shock absorber to an economic downturn in 2023.
All household debt – mortgages, home equity, credit card, and auto and student loans – relative to income stood a little over 100% as of September 2022, compared with a peak of 134% in 2008. Although this ratio rose a bit during the pandemic and recession, the current level is roughly where it was 20 years ago. Debt to assets is even more encouraging. At 13.2%, the ratio of household debt to assets is back to levels last seen in the early 1980s.
Chart showing U.S. household debt to assets ratio from 1946 to September 30, 2022. The latest figure is 13.2%. If you are in need of the data behind this chart, please email BBHPrivateBanking@bbh.com.
This data is admittedly lagged, but we use it here not to gauge the timing of a recession, but the likely severity. Healthy household balance sheets don’t mean that the economy will avoid recession, but it does imply that there is enough cushion on household balance sheets to make a recession shorter and milder than the historic norm.
Inflation and the Fed
This is the point in the economic cycle when the Federal Reserve usually begins to saddle up and ride to the rescue by easing monetary policy. Recall, however, that the Fed has a Congressional mandate to foster “maximum employment, stable prices, and moderate long-term interest rates.” These goals can be mutually exclusive from time to time, although for most of the past few decades the absence of inflation has allowed the Fed to focus primarily on economic support. The sharp recovery from the pandemic, fueled by trillions of stimulus spending, led to higher inflation than the U.S. has experienced in many decades. Disrupted supply chains exacerbated price pressures, leading to a perfect storm of rising demand and constrained supply.
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These pressures have begun to ease. It now seems likely that consumer inflation, as measured by the Consumer Price Index (CPI), peaked in June 2022 at 9.1% and has declined for six consecutive months to end the year at 6.5%. This marks the lowest annual inflation rate since October 2021. As the nearby graph illustrates, most of the relief has come through a softening in food and energy prices, reflecting declines in the raw materials that drive this part of the inflation basket. We believe that this trend will continue into 2023, providing even more relief at the grocery store and the gas pump.
It is, however, probably premature for the Fed to declare victory just yet. First, note that the core measure of inflation – prices excluding food and energy – hasn’t declined meaningfully over the past year. Lower food and energy prices are great, but if the year-over-year change in this category falls to zero, we’re still left with core inflation of about 6%. Second, recalling the Fed’s mandate to facilitate “maximum employment,” with the unemployment rate at a 50-year low of 3.5%, there has arguably been no impairment – yet – in the labor market due to higher interest rates. We watch with growing interest headlines reporting layoffs mostly in the technology and financial sectors. As and when this anecdotal evidence begins to translate into unemployment data, we expect the Fed will broaden its attention beyond inflation, stop raising rates by midyear, and perhaps even ease monetary policy in the second half.
The futures market for the fed funds rate indicates precisely this. Markets expect the Fed to raise interest rates at the February 1 meeting, followed by another hike in March or May. This would bring rates to around 5% by early spring. From there the futures market anticipates a relatively quiet summer, followed by an increasing likelihood of interest rate cuts in the latter half of the year. This is, of course, neither a guarantee nor a perfect crystal ball, but this interest rate path is entirely consistent with a mild recession taking hold at some point around the middle of 2023.
What Could Go Wrong?
All else being equal, this is a benign scenario for financial assets, at least later in the year. Bond prices would benefit from an end to rising interest rates, while bond investors would continue to earn higher coupon rates than they have seen in quite some time. Similarly, the derating in equity valuations would likely ease on the prospect of flat or even lower interest rates. The problem, of course, is that all else is never equal.
Like a horror movie zombie that refuses to die once and for all, the debt ceiling is back on center stage this year. As readers are well aware, the debt ceiling limits the amount of cumulative money the U.S. can borrow by issuing bonds. Ironically, the debt ceiling was first created in 1917 to make it easier for Congress to spend money in response to World War I. Rather than authorize borrowing to accompany each and every spending bill, Congress instead decided to create a cap to cover all necessary and foreseeable expenses. The unintended consequence, of course, is that Congress needs to raise the cap from time to time in order to pay for money already committed, making it the perfect political football in a divided government.
Chart showing the debt ceiling and outstanding U.S. federal debt from 1973 through 2022. If you are in need of the data behind this chart, please email BBHPrivateBanking@bbh.com.
As the nearby graph illustrates, the debt ceiling has done very little to constrain the growth of federal debt. Indeed, graphically this looks more like a debt ladder than a debt ceiling. The limit on federal debt was last raised in December 2021 to the current level of $31.4 trillion (or $31,381,462,788,891.17 for those of you keeping very close track). On January 13, Treasury Secretary Janet Yellen announced that outstanding U.S. debt had reached this ceiling and that the Treasury Department had begun to delay certain payments, mostly consisting of delaying pension payments into civil service and postal retirement funds. These “emergency measures” have been well honed in previous debt ceiling crises and should buy time until June or so before the U.S. runs a real risk of defaulting on a repayment of Treasury debt.
The debt ceiling has historically served as political kabuki theater, as politicians wring maximum political benefit from brinksmanship before arriving at an 11th-hour agreement to raise or suspend the ceiling and avoid the unthinkable implication of default. There is an old adage in financial markets that whereas the most predictable risk is the least dangerous, the least predictable risk is the most dangerous. It is precisely the seeming predictability of the debt ceiling debate and the expectation of a benign outcome that makes the current environment so dangerous. At the risk of offering a political observation, there is a vocal minority of members of the 118th Congress that do not seem to grasp the implications of a default, even if technical and brief. Treasuries are the lifeblood of the global financial system and play a role as counterparty assets and assurances throughout the world. The dollar enjoys the “exorbitant privilege” of being the global reserve currency, which creates more demand for Treasuries than the U.S. economy alone generates. This allows the U.S. to enjoy lower interest rates than would otherwise be the case, and it would be the height of economic foolishness to sacrifice this privilege on the altar of political posturing.
How might this play out? One of the more outré suggestions in certain economic circles would take advantage of a loophole in the law that allows the U.S. Treasury to mint gold and silver coins only in specific denominations (such as $50 or $100) but places no such restrictions on the minting of platinum coins. The Treasury, therefore, could theoretically mint a single $1 trillion platinum coin and deliver it to the Fed in exchange for $1 trillion of cash, which the Fed, as the central bank, can legally print. This is, of course, ridiculous, although the whole concept of refusing to finance spending bills that Congress already committed is similarly ridiculous, so perhaps this is an idea whose time has come. Originally a fringe idea floated in social media circles, more and more mainstream economists are warming up to this idea.
In a much more traditional vein, the debt ceiling problem could be solved, or at least postponed, through the issuance of premium bonds. Here, too, there is a bit of a loophole, in that only the face value of government debt counts toward the debt ceiling. As an example, consider a $100 face value bond issued today with a 4% coupon and a one-year maturity. The face value of $100 adds to outstanding debt, while a buyer of this bond adds roughly $100 to the U.S. Treasury upon purchase. But what if this same bond were issued with a coupon of 104%? The price would be much higher, given the premium yield, but the face value of $100 is unchanged. This would result in a $100 addition to the national debt, but around $200 of cash income to the Treasury. Add a bunch of zeros to this simple example, and voila, no debt ceiling crisis.
Outside of financial approaches, constitutional scholars have variously argued that the debt ceiling itself violates the 14th Amendment to the Constitution, which states (among other things), that “The validity of the public debt of the United States authorized by law … shall not be questioned.” This amendment was ratified in 1868 in the wake of the Civil War out of fear that previously Confederate states might renege on Union-issued debt. Might the Democratic caucus choose to make a constitutional issue of the debt ceiling? Does the presence of a debt ceiling speak to what debt is “authorized by law,” or not authorized by law? Does the Biden administration want to pick a fight that would head swiftly to the Supreme Court? We don’t know. What we do know is that the debt ceiling fight could easily weigh on economic and investment sentiment as we approach the real deadline sometime this summer, and as politicians seek the least bad solution to a problem that they themselves created.
Long-term investors should make a distinction between those developments that could pose a sentimental or psychological risk, and therefore impair asset prices for some time, and those developments that pose a fundamental risk, which might impair values. The latter is more serious. For now, we place the debt ceiling debacle into the category of sentimental risk while acknowledging that the game of debt ceiling chicken could result in a car crash if neither side blinks.
What to Do?
There are countless approaches in the wide world of investment management, but they are all ultimately variations on one of two strategies. By far the most popular investment strategy is price anticipation. Turn on the television or pick up any financial newsletter, and someone is usually recommending that investors buy something to benefit from an expected rise in prices or sell something to avoid an expected decline. An analyst might insist that you buy a stock before an earnings release that he expects to surprise on the upside, or sell a bond before the Fed meets and raises interest rates again.
The challenge with the price anticipation approach is threefold. First, an investor has to know the future. If we have learned nothing else over the past few years, surely we have learned that the future is forever an unknowable place. To make matters worse, when we think of uncertainty, we naturally think of examples like the roll of a die. In reality, the future is far messier than a six-sided die. It is more like a die with infinite sides and an unimaginable (ex ante) range of outcomes. Who had global pandemic on their bingo card at the end of 2019? A land war in Eastern Europe? History continues to surprise, both at the macro and micro level.
Second, even if your outlook is infallible, your timing has to be perfect as well. An old maxim holds that being too early is indistinguishable from being wrong. Recall Fed Governor Alan Greenspan’s famous observation in 1996 that the stock market was plagued with “irrational exuberance.” Fundamentally he was right, but investors who sold on the basis of that assessment missed a bull market that doubled over the subsequent three years.
Even then, it’s not enough to know what the future holds and when. A price anticipation strategy thirdly requires that an investor know what a particular forecast means for asset prices. Consider the pandemic: If in January 2020 you had known with precision the timing and gravity of the COVID-19 pandemic, would you have concluded that equity prices would rise close to 120% from the lows, even while the pandemic continued to spread? It’s easy in hindsight, but impossible in the moment.
Another, and far rarer, investment approach offers a way out of this tripartite challenge. Instead of pursuing a strategy of price appreciation, our investment teams at Brown Brothers Harriman, as well as those external managers with whom we partner, focus their efforts on value recognition. The difference may seem subtle, but the approach is profoundly different. Whereas we certainly focus on the various moving parts in the global economy and financial markets as a way to identify and assess risk and opportunity at the asset class level, we commit capital on a security-by-security basis into assets that have a greater than average degree of control over their own destiny and that we can acquire at a discount to the fundamental value of the asset. Rather than predicting the future state of play, the timing of that state, and how prices might react, we rely on fundamental research and rigorous valuation analysis. In a price anticipation strategy, price is the dominant variable and the focus of attention. In the value recognition strategy, price is secondary to value. The difference between price and value creates the investment opportunity.
We believe that this is the right way to preserve and grow capital in any market environment and is particularly important in a market still disrupted by the economic shocks of the past few years. It doesn’t work every time, as we have seen lately. Over shorter timeframes, investor sentiment swings wildly from unbridled optimism and enthusiasm (2021) to outright despair and loathing (2022), and prices can deviate wildly from value. Over time, however, we are confident that fundamental value wins out.
Happy New Year. Here’s to a healthy, happy, and prosperous 2023.
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