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The US is looking overpriced.

  • Saturday, May 27, 2023

 Kevin McCarthy Speaker of the United States House of Representatives

US annual headline CPI inflation fell from 6% in February to 5% in March and 4.95% in April while core inflation that excludes food and energy costs rose slightly from 5% to 5.5%. US CPI has fallen every month for the past 10 months starting from June 2022. Along with data that suggests we can expect falling new job vacancies and lowering goods prices all indicate that US CPI inflation is set to continue to fall.

While there are pockets of rising inflation with food costs being an example, the Fed Funds rate of 5.25% is higher than the rate of CPI inflation. The risk for the Fed is that if it overshoots its tightening policy more than is needed, that leads to a financial problem in the banking sector and adds to recessionary pressure.

There are inflation drivers outside the control of central banks such as energy costs. Brent Crude oil prices have lifted due to OPEC production cuts but remain sensitive to recession pressures. Oil prices are currently US$78 pb down from the June 2022 high of US$122pb.

Job creation in the US remained robust in April despite higher borrowing costs. Employers added another 253,000 new workers in April, versus 165,000 in March. The unemployment rate came in at 3.4% versus 3.5% in March. 3.4% unemployment is a multi-decade low.

The latest new jobs created of 253,000 is below the 12-month moving average of 339,000, indicating a softening employment trend. Importantly, employment growth has slowed to an annual 2.9% increase in April, a steady deceleration over the past year. Average weekly hours in the private sector have tailed off to their lowest level since the pandemic and is an early indicative signal that businesses are cutting back on labour.

Average hourly earnings from the payroll report, slowed to an annual rate of 4.4%, against a cyclical peak of 5.9%. Importantly, the number of workers quitting their jobs to look for better paid opportunities has steadily fallen over the past year. As a lead indicator for the overall compensation rate for workers, the quit rate suggests that the risk of an upward spiral in wage rates has likely fallen.

Even with this softening in the jobs and wage data, there is still a long way to go before the Fed can feel comfortable that the labour market has eased sufficiently to be consistent with 2% inflation over time. After all, the unemployment rate is close to a 50-year low.

On balance, given that there are still plenty of job vacancies, the participation rate has yet to recover to before the Covid outbreak and initial jobless claims have been stable at a low level, employment is still likely to grow, but at a slowing pace. This suggests there is a decent chance that the US can avoid an economic hard landing.

Markets expect the Fed to now pause any further rate rises. Slowing inflation is increasing the likelihood of the Fed coming to the end of its interest rate rises. If the BoE and ECB continue to rise their interest rates, this could lead to a depreciation of the US$ against other major currencies. A weaker US$ will help improve the price of equities and bonds.

Negotiations over the US debt ceiling in order to prevent the US government from running out of money are headed down to the wire. The US Treasury has said that Congress must agree to raise the debt ceiling by 1 June or the US will run out of cash to pay its bills. Analysts say they expect Wall Street to remain on edge the closer it gets to 1 June. But for most of the month, markets have remained remarkably unmoved, betting that a deal will get done. However, just in the past days has the chance of a default hit market values.

Analysts believe the possibility of another downgrade remains remote, but the three ratings firms have signalled they are closely watching what is happening in Washington. Fitch Ratings put the US on a negative watch, the first step toward a downgrade, citing “increased political partisanship” and weak governance compared to other countries that hold its top rating. “The brinkmanship over the debt ceiling, failure of the US authorities to meaningfully tackle medium-term fiscal challenges that will lead to rising budget deficits and a growing debt burden signal downside risk to US creditworthiness,” the company said.

Markets have been volatile this year but data remains robust and with policy expectations now around pausing rate rises we could, subject to the banking situation and US debt ceiling negotiations being successful, see some stronger equity performance over the months ahead. Any fall into recession should lead to an out performance by fixed income assets for the rest of 2023.

One factor that does have an impact upon the health of the US economy is the level of consumer spending. Interestingly, consumer confidence has improved from September 2022 lows as one might have expected, that the higher costs of living to have hurt consumer confidence. This has also been less the case in Europe as energy prices have fallen back to pre-Ukraine invasion levels at €39mwh, thanks to mild weather and high storage levels. US unemployment is currently 3.4% in April which is a 50-year low. Companies are not making mass layoffs so the threat of job losses are not hitting consumer confidence. Household balance sheets improved over the Covid lockdowns so that savings rates are above historical averages.

However, consumer weaknesses have started to show through. Data from Q1 on US personal disposable income and spending suggests that over the coming months that US consumer spending will start to decelerate. Such a slowdown, will help control inflation and help the Fed pause on further interest rate rises. A decline in inflation will have a positive impact upon US equity and bond markets.

US equities have become less attractive recently due to the higher interest rates and a risk of recession. In the past US equities have had a low sensitivity to the global economic cycle and have been less volatile than global equities. However, since the start of last year, US equities have not provided their typical defensiveness in this economic cycle and underperforming since the start of 2022. A key reason appears to have been the high valuations of US markets against the backdrop of high valued stock generally underperforming as interest rates rose. The S&P 500, for example, has gained 1% over the past 12 months while the FTSE 100 gained 7.7%.

US earnings forecasts do not appear to reflect the risk of recession with analysts still forecasting solid growth across most sectors. Unless analysts have additional insight, the US is looking overpriced.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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