Market Synopsis – June 2024

Market Synopsis – June 2024

Jun 4, 2024 | 0 comments

Unpacking the requirements for a soft landing

Former vice chairman of Berkshire Hathaway, Charlie Munger, once said, “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” With this in mind, we will look at the opposing view to our base case expectation of a hard landing and unpack what needs to happen for the US economy to achieve a soft landing and avoid a recession.

A sound financial system

After the collapse of Silicon Valley Bank last year, investors became hyper-focused on the health of regional US banks. Now, 15 months later, many of the same underlying problems remain despite the attention of investors and media moving on long ago. Notably, as Figure 1 illustrates, mark-to-market losses on commercial bank balance sheets have shown little improvement, remaining about the same as they were a year ago.

Figure 1 – Regional bank balance sheets hold significant unrealised losses

Furthermore, US regional banks are still heavily exposed (see Figure 2) to the ticking time bomb that is US office real estate. The combination of rising interest rates and work from home induced changes to office space demand have led to an ongoing rise in office loan delinquencies.

Figure 2 – Regional banks hold most of the office real estate loans

In the consumer segment, things are not fairing much better: In Q1 2024, delinquency rates on credit cards and auto loans have risen above 8%, the highest levels since 2012 – a period in which the unemployment rate was over 8%. In response, we expect that banks will continue their current trend of tightening lending standards. Typically, lending standards lead loan growth by around one year, thus, as standards rise, we expect lending to continue to slow in the coming months.

So, is a soft landing still possible given the current condition of the financial system? To feel confident on the prospects of a soft landing, we would need to see a stabilisation of both lending standards and delinquency rates. Promisingly, several prominent banks and credit issuers noted in their Q1 earnings calls that charge-offs on consumer loans were starting to decline. If charge-offs continue their decline, lending standards should stabilise, and a soft landing becomes just that much more likely.

A strong US labour market

A low US unemployment rate is not only important to the health of the financial sector but is also critical for a soft landing to be realised. The good news is that for the past 27 months the unemployment rate has remained steadily below 4%. Bountiful job openings have insulated the labour market for the past two years, allowing both newly unemployed workers and new entrants to easily find employment.

However, the jobs-workers gap (the number of excess job openings relative to unemployed workers) has been declining since 2021 and is now three-quarters below its peak. If this trend continues, there will be more unemployed workers than job openings by early 2025. At this point, the unemployment rate could start rising rapidly.

While the labour market may be cooling, there are some positives. The Kansas City Fed Labor Market Conditions Indicator, which incorporates 24 national labour market variables, remains well above its historic average – see Figure 3. If the series does stabilise near its long-term mean, a soft landing becomes a possibility.

Figure 3 – Labour market conditions continue to weaken

Thus, while the current low unemployment levels point to a possible soft landing, we remain hesitant until we see an actual pivot in the declining trend of the job-workers gap.

Inflation and the Fed

The longer inflation takes to fall the further the possibility of a soft landing dwindles. Simply put, if inflation recedes, the US Federal Reserve (“Fed”) will look to cut rates, and a more economically supportive backdrop will be ushered in. However, with inflation stubbornly hovering around 3.85% since June 2023, when will it decline to the Fed’s 2.5% target?

Well, one could argue that inflation might have already fallen. Outside of a few pandemic-related “catch-up” categories such as shelter, health care, and auto insurance, CPI inflation on a year-over-year basis has been below 2% for 12 months now – see Figure 4. Furthermore, if labour markets continue to weaken as we expect, wage growth will cool, and as a result inflation is unlikely to meaningfully rise again.

Figure 4 – Outside of the “catch up” categories, inflation is back to target

Having said that, the Fed still does not appear willing to pre-emptively cut rates given the risk of a second wave of inflation. Just last week Fed Vice Chair of Supervision, Michael Barr, reaffirmed this stance. He commented that the “disappointing” first-quarter inflation readings “did not provide me with the increased confidence that I was hoping to find to support easing monetary policy.” Given these sorts of views among Fed members, it is possible that the Fed will eventually find itself behind the curve in easing monetary policy.

If the Fed maintains their hawkish stance towards inflation prints as 2024 progresses, a soft landing becomes less likely as economic drivers such as consumer spending become increasingly constrained.

Cyclical spending

Over the last three years consumers have sustained their discretionary spending by drawing on their excess pandemic savings. This has misled many market commentators who assumed the heightened consumption habits reflected a strong US consumer. Unfortunately, as Figure 5 illustrates, these savings are now largely depleted.

Figure 5 – Consumers are running out of reserves to sustain their consumption habits

Further evidence that the consumer is under pressure can be seen in Figure 6 where the personal savings rate has fallen to just 3.2% in April, less than half of its pre-pandemic average. Under pressure and with no remaining savings consumers typically turn to debt to supplement their consumption needs. In 2008, the last time the savings rate was this low, homeowners borrowed against their home equity lines of credit (“HELOCs”) to maintain their high levels of spending.

Figure 6 – The personal savings rate remains well below average

However, this time banks have made HELOCs harder to access, and instead consumers have turned to their credit cards. In fact, credit card balances continue to grow at rates materially higher than they did before the pandemic – see Figure 7. However, as banks continue to tighten their lending standards, it is likely that this source of capital will also soon dry up. Leaving consumers with few options left to sustain their discretionary spending and an economy heading for a hard landing.

Figure 7 – Consumers are relying on their credit cards to sustain their consumption habits

The only way consumer habits could improve the odds of a soft landing is if aggregate demand slowly declined as consumers shifted to a higher and more sustainable personal savings rate. This may be difficult to achieve given that if all consumers simultaneously and abruptly limit spending it could lead to weaker employment growth, and by extension, weaker income growth.

Investment takeaways

For the US economy to achieve a soft landing it would need to see a stabilisation of both lending standards and delinquency rates in the financial system, a reversal of the present trend in the job-workers gap, receding inflation and a dovish Fed and, finally, a consumer that is able to gradually shift their consumption habits. While these outcomes are all possible, and by extension so too is a soft landing, we still believe that these developments are the less likely outcomes. Instead, we believe the more likely outcome is that the economy undergoes a “phase transition” from cool to frozen towards the end of 2024 or in early 2025 as we have written before.

If you interested in finding out more about how cognisance of the macroeconomic backdrop helps our clients invest, connect with Integrity Asset Management and let us help you navigate your investing journey.

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Source: Bloomberg, 31 May 2024