By: Stash Graham
July brought a good month broadly for our accounts as at-risk assets saw solid price appreciation on the backdrop of a growing chorus of people assuming a “soft” or “no landing” when discussing the U.S. economy. While the host of leading economic indicators that we observe flash warning signs, we must admit that we continue to admire how tight the labor market is. We have some concerns about the forward direction of the labor market for reasons that we have written about on a couple of occasions in the last few months. Regardless, people consume at rates high enough for the economy to grow by around 2%. The 2nd quarter real GDP estimate was a consensus, beating 2.4% growth. The real GDP estimate beat was due to the GDP Price Deflator coming in at 80 basis points below expectations. The Nasdaq Composite grew 3.8%. The S&P 500 and Dow Jones Industrial appreciated 3.1% and 3.2%, respectively. Precious metal haven, gold, had a good month, increasing 2.85% in price.
The Federal Reserve’s FOMC met last week and decided to raise the bank borrowing rate by another 25 basis points. Notably, the Federal Reserve internal staff is now forecasting a narrow avoidance of an economic recession this year. The Congressional Budget Office also released a report last week concluding the same. Skeptical market participants underestimated the American household’s consumption resilience as families continued to spend. Now, it can be debated how consumers finance these purchases and whether that is sustainable for the near future, but consumers are spending. Finally, Fed Chair Jerome Powell told journalists at the press conference following the July FOMC meeting that he expected no rate cuts in 2023.
Last month, we wrote that we have been observing and making several different types of investments within the banking industry in the past few months. Last week, we sent a digital brief on our Wells Fargo preferred/subordinated debt positions. Additionally, for our more conservative investors, we have invested in short-dated bonds providing credit to regional bank Fifth Third. For some of our risk-seeking investors, we have invested in a few small regional/community banks with early success. As a part of our due diligence, we have talked to many different parties in the banking industry, from CEOs to sector-specific institutional investors. It is unanimous that the banking sector rebound has been “too fast, too soon.” What was a liquidity crisis has now turned into an earnings problem. An earnings problem also has a chance to become a credit problem if the economy does contract within the year. The latter (credit problem) is a point debated, but the former (earnings problem) is widely agreed upon. The market enjoyed the 2nd quarter earnings figures across the banking landscape, but earnings pressure is only growing. Funding and borrowing costs rise faster than asset yields (i.e., the interest rate on an issued loan or a purchased U.S. Treasury). We will continue to monitor this sector and be decisive with our actions. We could unload some of our appreciated banking sector positions to lock in returns and keep an eye on buying back these positions in the spring when the market adjusts to contracting earnings growth.
Finally, the various data sources regarding the U.S. economy have been providing mixed signals. As mentioned earlier, Gross Domestic Product (GDP) saw real economic growth of +2.4% for the 2nd quarter. Gross Domestic Product is the sum of all expenditures by American households, governments, and businesses while adjusted for net trade. Gross Domestic Income (GDI) measures what everyone earns in income. The generally accepted thought is that GDI and GDP would mirror one another over extended periods, as one person’s expense is another person’s income. It is concerning that we have had a historically high decoupling over the last nine months between the two economic measures. GDI has shown consecutive quarters of economic contraction. Fortunately, we have a white paper from the Federal Bank of Cleveland that observed that throughout the history of these metrics (started in the late 1970s), when GDI and GDP have moved in opposite directions, in every instance, GDP gets revised towards the direction of GDI and not the other way around. As such, in a couple of quarters, we would not be surprised to see the initial estimate of 2nd quarter’s U.S. GDP get revised lower, indicating weaker economic growth.
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