The last week of March saw several significant foreclosures (hundreds of millions of dollars per property). These included properties in San Francisco and Mountain View, California, a large complex in Washington, DC, and a medical office building (still under construction) in southern Florida.
Year-on-year change in national rental index (2019-present)
Apartment list
Delinquencies on leveraged loans now exceed 6% (normal is <3%). This level is approaching the level of the 2001, 2008 and 20 recessions. According to Moody's, office vacancies are at record levels. Commercial real estate (CRE) prices are in free fall. According to Rosenberg Research, 29% of all commercial properties and 56% of office loans now have negative equity. Shopping centers are struggling and apartment buildings are overbuilt (falling rents). It will be instructive to see the increases in their loan loss provisions when banks report their first quarter results in April.
Stock markets
But despite the growing problems in the CRE sector and the emerging cracks in the economic landscape, stock prices continue to reach new heights. Both the S&P 500 and DJIA hit record closing highs on Thursday (March 28), while the Nasdaq was just a hair away from its record closing high set on March 22. The stock market continues to be driven by momentum and traditional valuation metrics such as the P/E ratio (price-to-earnings ratio) are well above their median values (see chart below).
P/E ratio for S&P 500: 29.00
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Cracks in the foundation
Meanwhile, over the last quarter or so, we have seen flat to declining industrial production, lower retail sales, shrinking exports, flat to negative capital spending, and a net loss of full-time jobs (which have been replaced by part-time jobs). But given this data, both the Federal Reserve District Bank of Atlanta and the St. Louis Federal Reserve District are forecasting an impressive +2.3% GDP growth rate in the first quarter. This seems extremely optimistic. Furthermore, the media still promotes the mantra “the economy is strong.” We believe that growth will be much lower, as do many research houses. For example, Rosenberg Research forecasts GDP growth of -0.5% in the first quarter based on trends in the following data from the past three months:
- Industrial production (-2.7% annual rate (ARAR))
- Retail sales volume (-5.3% AR)
- CoreCORE Capex Orders (-0.9% AR)
- Exports (-1.1% AR)
- Full-time employment (-5.2% AR)
Additionally, Rosenberg reports that same-store sales contracted in U.S. dollar terms (-0.2% YoY). Worse still: when adjusted for inflation (i.e. taking volumes into account), this number becomes negative (-1.3%) for five quarters in a row. This was last seen during the Great Recession (see chart below).
Additionally, when we look at Wall Street's second quarter earnings growth estimates, they are flat, and we have the major retailers (TGT, HD, LOW, WMT) all noting in their fourth quarter earnings releases that consumers have strained their wallets. Recent retail reports from companies like Lululemon and NikeNKE were also negative, as both reported disappointing sales, slowing demand and slower traffic.
Volume growth in consumer companies
Bloomberg, Rosenberg Research
In previous blogs we have commented on the rapid increase in credit card balances. This is because personal savings have been depleted. And now we're seeing rapidly increasing delinquencies on credit cards, auto loans and other consumer loans.
Consumer loans: default rate
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Real estate prices and the “wealth effect”
Rising real estate prices often lead to what economists call the “wealth effect.” That is, when house prices rise, homeowners tend to spend more because they feel they can afford to consume more because their “wealth” is greater. This particular effect is now wearing off. Both the Case-Shiller and FHFA home price indexes exhibit strong negative slopes, with the FHFA index already in negative territory. The real estate boom could well end.
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The Conference Board's consumer confidence index fell in March, while its future expectations sub-index is now at its lowest level in six months. Less than 15% of respondents expect the economy to improve in the next six months, while plans to buy a car or major household appliance were the weakest since July 22 and September 2011 before that.
Growth forecasts
While the parent bank, the Fed, recently raised its 2024 GDP growth forecast from 1.4% to 2.1% and cut its year-end U3 unemployment rate from 4.1% to 4.0%, reports from the Fed's regional district banks not so optimistic.
- The Dallas Fed's manufacturing index was -14.4 in March, even lower than February's -11.3. Production, new orders and deliveries were negative and the workweek shrank. The Dallas Fed's services index was also weak at -5.0; again lower than in February (-3.9).
- The Philly Fed Non-Manufacturing Index, which was at -18.3 in March, has now declined for three straight months. New orders, backlogs and inventories declined. And full-time employment growth was the lowest since last June.
- The Richmond Fed's manufacturing index was also negative in March (-11), again worse than February's reading of -5. This was the sixth consecutive month of decline. The indices for incoming orders, capacity utilization and order backlogs were negative. In addition, business spending fell at its lowest level since July 2020.
- The graphic shows the Chicago Fed's National Activity Index. This comprehensive index has been in negative territory since the fourth quarter of 2022.
Chicago Fed National Activity Index
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The Fed and interest rates
Chairman Powell and other FOMC members continue to insist that they need to see more “good” inflation data before moving to cut interest rates. In January and February we hit some bumps on the road to disinflation. At his recent press conference after the last Fed meeting, the chairman eased market fears and said the Fed would not overreact if inflation data for January and February came in higher than expected.
On Friday (March 29), the Personal Consumption Expenditure Index (PCE), the Fed's favorite inflation indicator, recorded a reading of +0.3% (+0.332% to the third decimal place), slightly below the reading of +0, 4% in January (+0.376%). . However, due to “base effects”, the annual rate (2.45%) increased slightly from January’s figure of 2.43%, the first increase in some time, albeit very slightly. As soon as inflation falls to the target value, such deviations are statistically to be expected.
The core PCE measure, which excludes the volatile food and energy sectors, also rose 0.3% in February and 2.8% year-on-year, down slightly from 2.9% in January. The PCE report will not change the FOMC's view that the final leg of the inflation fight will take a little longer.
As can be seen from the chart below, the core PCE price deflator is lower than the core CPI index. That's good news because that's the index that the Fed responds to.
March CPI will be announced on Friday (April 5). As we have discussed in previous blogs, we believe that the delayed protection component in the CPI will de-escalate the annual CPI inflation rate by year-end. Markets appear to agree with this assessment, as the likelihood of a rate cut in June has now risen to up to 70%. The Fed's June 11-12 meeting is still nearly two and a half months away. A lot can and will happen in this interim.
Final thoughts
Commercial real estate problems are increasing and foreclosures are still in their early stages. We expect a major impact on the financial sector in the next few months. This alone will plunge the economy into recession. Banks' loan loss provisions in their upcoming first quarter financial reports will shed a lot of light on this issue.
Despite increasing economic downturns, the stock market continues to reach record-breaking closing prices. Traditional valuation metrics strongly suggest that stocks are in overvaluation territory.
Cracks also continue to appear in non-financial sectors. The manufacturing sector already appears to be in recession, and the consumer who has driven this economy in recent quarters now appears to be out of energy.
While the Fed recently raised its 2024 GDP forecast and lowered its year-end unemployment rate forecast, new data suggests weakening retail sales, manufacturing and housing construction. The Regional Fed Bank surveys suggest the same.
Despite the increases in January/February, all other metrics continue to show disinflation (slowing inflation rates). Instead of Fed Chairman Powell taking a more hawkish stance due to the “bumps in the road,” he surprised markets at his recent press conference by reassuring them that the battle against inflation was won. We agree with this assessment. Due to the lag in protection data built into the CPI, significantly lower inflation (i.e. disinflation) is all but guaranteed. Therefore, the chances of a rate cut in June now appear to be high.
(Joshua Barone and Eugene Hoover contributed to this blog.)
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Robert Barone, Ph.D. is a Georgetown-educated economist. He is co-portfolio manager of UVA's Fixed Income ETF (Symbol: FFIU). Robert is also a Managing Director and Financial Advisor at Farther Finance Advisors, LLC (“Go Farther!”). Known nationally for his writings, Robert's storied career includes serving as a professor of finance, CEO of a community bank, director and chairman of the Federal Home Loan Bank of San Francisco, director and chairman of CSAA Insurance Company (the AAA brand), and Director of the AAA Auto Club of Northern California, Nevada and Utah Robert is currently a director of Allied Mineral Products (Columbus, OH), America's leading refractory company.
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