Two weeks into the new calendar year, and feels like all heck has broken loose. There has been a lot of red ink in the US financial markets. Stocks, bonds, currency? Take your pick. US dollar-denominated assets have been taking it on the chin after three years of exceptional, arguably outsized, returns. It hasn’t been pretty.
I suppose that is why there is Alka-Seltzer, and I haven’t lost a minute of sleep in January because of anything currently happening in the markets. Now, the chicken I cooked last Saturday night is a different matter altogether. That aside, how can I be so calm in this choppy sea of uncertainty?
As a brief note of explanation for everyone under, say, 40 years old: “Alka-Seltzer is an effervescent antacid and pain reliever first marketed by the Dr. Miles Medicine Company of Elkhart, Indiana, United States. Alka-Seltzer contains three active ingredients: aspirin (acetylsalicylic acid) (ASA), sodium bicarbonate, and anhydrous citric acid.[1] The aspirin is a pain reliever and anti-inflammatory, the sodium bicarbonate is an antacid, and the citric acid reacts with the sodium bicarbonate and water to form effervescence. (from Wikipedia).”
First things first, January is often a bad month for stocks. Through the end of last year, the S&P 500 has posted a negative principal return in January 55% of the time. By this measure, January is the worst month of the year for US stocks. The next worst is September, which has been negative 50% of the time. By comparison, over the previous 22 years, the S&P has posted 165 positive months out of 264, which works out to be 63%. Obviously, that means the market has been negative the remaining 37%.
For grins, the best month for stocks over this time frame has been April, which has had positive results an incredible 77% of the time. So, let’s chalk up some of this fortnight’s unpleasantness to, shall we say, seasonal factors. These are things which tend to happen at a particular time every year, sometimes for no legitimate reason.
Then, there are a number of people who have been wringing their hands and gnashing their teeth about the potential for up to 4 Fed rate hikes this year. Ouch, huh? Maybe, and only if, the Fed is so dimwitted as to “raise rates” to an extent where it “inverts the yield curve.” This is when short-term rates are higher than long-term rates. Intuitively, this would constrain the extension of credit in the financial system, as lenders typically borrow short and lend long.
Essentially, if the price of money is more expensive in the short-term than it is in the long-term, banks won’t make (as many) loans. When banks don’t make loans, the money supply tends to stagnate. When that happens, the economy tends to cool down. Ergo, an inverted yield curve has normally been bad for business, but not always.
On top of these concerns, there is no shortage of bricks in the proverbial “wall of worry.” Inflation. Supply chain bottlenecks. Shortages of just about everything. A paltry labor force participation rate. Discord and disunity in our government and society. Tensions with the Chinese, Russians, Iranians, and North Koreans. Or course, let’s not forget the ongoing COVID-19 saga, and I am sure I am leaving a few anxieties off the list.
However, where the rubber meets the road; when the dust settles; when the smoke clears, and when the cows come home, there is currently still more positive than negative in the US economy, at least as I type on 1/14/2022. Seriously, there is, and I will start from the top.
Make no mistakes about it; money is still incredibly cheap in the United States, as in free when adjusted for inflation. Consider this: this week, the Bureau of Labor Statistics (BEA) announced the trailing 12-month Consumer Price Index (CPI), the most commonly used gauge of inflation, was 7.0% for 2021. By comparison, the yield to maturity on the 30-year US Treasury Bond was 1.90% on 12/31/2021.
As a result, longer-term borrowing rates are less than the current rate of inflation, unless your credit score absolutely stinks. This means borrowers can pay back their loans with increasingly worthless dollars. The arbitrage, if you want to call it that, is essentially the difference between the CPI and the interest rate. If the former is greater than the later, the borrower “wins.”
Even more so than that, the yield curve continues to be positively sloped, meaning short rates are lower than long ones. As a result, banks can make a spread lending money. If they can do so, they will. As a result, the money supply will continue to grow which will stimulate economic activity.
But…but…what about the Federal Reserve tightening credit and all of that? Won’t that hurt banks? The best way to answer that is: it depends on the amount of floating rate loans a bank has. If a significant portion of its loan portfolio floats, or sets/resets off a predetermined index, every rate hike will likely increase its net interest income, until the yield curve starts to invert (which will constrain fixed rate lending).
As a result, the first several rate hikes of most Fed tightening cycles have the beneficial impact of: 1) increasing bank profitability, and; 2) decreasing future inflation expectations. Put another way, higher earnings and lower interest rates.
Admittedly, this is “down in the weeds.” So, let me mention a few, more street friendly, observations in bullet point format:
- The NFIB Small Business Optimism Index is currently the 20-year average. When business owners feel good about the future, they tend to invest and hire more.
- The official US Unemployment Rate is a miserly 3.9%. Basically, if you want to have a job, you can find one.
- M2, the official money supply gauge, swelled in excess of $2.3 trillion in 2021. More money is generally better than less, unless you are Venezuela or Zimbabwe.
- The Conference Board Consumer Confidence index remains comfortably above its 20-year average. In a consumer driven economy, a confident consumer is always a good thing.
- Capacity Utilization rates are back to pre-pandemic levels. This means US manufacturing is back on its feet.
- The Baltic Exchange Dry Index (measures international shipping costs) has plummeted since 10/07/2021, from 5,650 on that date to 1,873 on 01/13/22. This should help to alleviate inflationary pressures.
- The Conference Board US Leading Index has been positive for the last 19 consecutive months. It is hard to find a rough economic patch when this is, or has been, the case.
- Foreclosures, as a percent of total loans, are at a 30-year low. (0.46%).
- The ‘loan to deposit’ ratio is currently 60%. This means banks have a huge amount of capacity to extend credit.
- Household wealth increased in excess of $21 trillion for the 4 quarters ending on 9/30/2021. More societal wealth is ALWAYS better than the alternative.
- While higher since the end of 2020, 30-year fixed-rate mortgages are currently hovering around 3.5%. That is half the current rate of inflation. As a results, borrowing rates are still attractive for potential homeowners in both absolute and relative terms.
- Both primary ISM surveys remain at relatively elevated levels, with very high levels of new orders and production.
Okay, I promised I wouldn’t get into the weeds, and there I go. I suppose I just can’t help myself, particularly when there is a bunch of “red ink on the screens.” Simply put, there is a lot of good news, and the sky is definitely not falling. Of course, we can always have a so-called black swan event; however, as of January 14, 2022, things are looking pretty decent for both the economy and the markets.
Of course, a lot can happen between now and the end of the year. No argument. However, whatever does happen will be topics for discussion in future editions of Common Cents.
As always, I hope this newsletter finds you and your family well, and may your blessings outweigh your sorrows not only on this day but on every day (and don’t forget to listen to our Trading Perspectives podcast)!
Chief Economist
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.