Yesterday, we had an interesting day in terms of new economic and monetary data points.  For the second month in a row, Consumer Price Index (“CPI”) came in below expectations, flat month over month vs a 0.1% expectation with cooling in services and housing — finally.  This seems to suggest that the “spike” we saw in the first few months of 2024 was an anomaly and was reinforced this morning, when the Producer Price Index (“PPI”) for May also came in well below expectation (-0.2% actual vs. +0.1% expected). 

Despite this demonstrated progress, the Fed decided to deliver a widely considered hawkish narrative through both its rate and inflation “dot plots” and Chair Powell’s comments, bringing back to the fore the idea that the Fed may make a big mistake – waiting too long to ease financial conditions, mainly by cutting rates, and causing an unnecessary recession.

Does our economy have something in common with how ice melts?

Over the last year, there has been plenty of talk and evidence of a surprisingly resilient and vibrant US economy, which stands in stark contrast to most countries around the world.  With the Fed fully engaged in a higher for longer policy, after an accelerated rate hike cycle, most economists have been predicting a recession since the beginning of 2023–forget about “soft landing”, very few predicted “no landing” during this period. 

While there is convincing data that some of this is “artificial”–such as immigration boosting employment (regardless of legality) and unsustainable emergency-level federal stimulus fueling growth – it has been an impressive run, nonetheless.  In fact, the Atlanta Fed’s estimate for Q2 US GDP growth recently rose above 3%, after declining to less than 2% just a few weeks ago.

You could definitely say there are signs of melting at the edges:

  • Real estate — The real estate industry has been hanging on for dear life, hoping that financial sleight of hand can continue to delay a reckoning while outlasting a “wait and see” Fed.  So far, this has largely worked.  But not completely.  Bloomberg recently reported (Real Estate Investors are Wiped Out in Bets Fueled by Wall Street Loans, June 6, 2024) about trouble with syndicated loans in the multi-family space, where many retail investors’ equity has been wiped out as sponsors unload properties at steep losses to meet liquidity needs and/or higher loan servicing requirements. Further, it flags an 8.6% distress rate for commercial real estate CLOs.  And then, there are increasing stories about steep realized losses on forced sales for distressed properties in the office space and owners handing back the keys to lenders.

    Certainly, the market is indicating it expects more distress as the massive commercial real estate loan portfolios of regional banks has led many to consider them “no touch” from an investing standpoint, despite seemingly attractive below market valuations.

  • Private credit — The darling of the fixed income world is showing signs of topping.  The pace of buyouts continue to slow, partly due to regulatory headwinds and partly due to higher capital costs.  Meanwhile, with the lack of an IPO realizations, some private funds are facing a liquidity crunch struggling to return cash to shareholders.  Banks, sensing a missed opportunity, have gotten back in the game and are undercutting deals and compressing spreads.

    As copious amounts of capital flowed into this asset class, it appears that some sponsors played fast and loose with terms to win deals.  This has investors worried about a phenomenon called “collateral stripping” that allows private equity firms to move certain assets out from under these loan agreements causing a deterioration by of credit quality.

  • Consumer spending —  Post-COVID, we have seen an orgy of stimulus-fueled spending first on goods and more recently on services.  As excess savings have dried up, consumers have continued to feed this beast with debt.  Many argue, it’s no big deal. Consumers are employed, wages are up and expected disinflation should ease cost-of-living issues.  But it seems that higher overall costs are finally starting to take their toll – the latest Michigan Consumer Sentiment Survey fell 10% in May, the lowest reading in five months.  Further, US household debt hit a record $17.7 trillion at the end of Q1’24 according to the NY Fed.

    Many consumer-facing companies have warned on quarterly earnings calls of overall slowing, more discerning consumers and idiosyncratic spending patterns across all aspects of retailing.  In fact, the S&P 500 Consumer Discretionary Sector Index is underperforming the S&P 500 Index by almost 5% so far in Q2 ‘24.

  • Capital Expenditures — Other than for AI chips (or perhaps because of it), capital spending across all industries is being deferred, if not delayed indefinitely.  The Institute for Supply Management’s May economic forecast indicated an expected 1% increase in capital outlays for 2024, down from a 12% expectation at the end of 2023 (and after successive years of 8.7%, 12.0% and 14.9% in 2021, 2022 and 2023, respectively). 

    According to the National Federation of Independent Business, small business optimism at 90.5 remains well below the 50-year average of 98.0.  Apparently, financing seems to be the biggest concern.  Indeed, according to Equifax, default rates on small business loans rose to an annual rate of 3.2% in April, the highest level in ten years.

But, could the current economic temperature lead to a full financial meltdown? 

Remember the banking crisis from February 2023 materialized seemingly out of nowhere as rapidly rising rates caught some financial institutions massively offsides in terms of liquidity and called into question the stability of the financial system.  Can we count on another massive Fed rescue this time?  They certainly want us to believe “we got this.”  Increasingly, though, the Fed is walking on thinner and thinner ice.

As Rita McGrath points out in her book, Seeing Around Corners, change happens slowly at the edges and then all at once–much like a melting ice pack eventually heaves off a massive iceberg. The question is will the economy continue to heat up or will the methods of our leadership cool things off in time?

Sources: Bloomberg, Validus research

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