Viewpoints

In Q1, the combined output of the cyclically sensitive motor vehicles and residential housing sectors expanded by 1.3% annualized, slightly better than the 1.1% growth for the overall economy and the first quarterly gain since late 2021. Also, the Q1 data shows that operating profits gained sequentially quarter over quarter and year over year. The rebound in cyclically sensitive sectors and profit data run counter to the recession forecasts. All economic recessions have standard features; declines in cyclically-sensitive sectors and drops in operating profits. Those features are missing at this time.

S&P purchasing managers manufacturing index rose over one percentage point to 50.2 in April. That’s the highest level in six months, driven by new orders, production, and employment gains. Thus, the rebound in cyclically sensitive sectors has continued into Q2.

Recessions forecasts are linked primarily to the inverted yield curve and the decline in the leading indicators. Questions over the accuracy of the signal from the inverted curve stem from the Fed's new policy tool, quantitative easing (QE). Since the Fed now actively purchases substantial quantities of long-duration fixed assets to keep a lid, or even depressing, on long-term interest rates, how can the yield curve signal be as reliable as in prior periods?

History shows that lower long-term borrowing costs often lead to faster growth in cyclically-sensitive sectors. The yield on the 10-year Treasury has declined 75 basis points in the past six months, and cyclically sensitive sectors have rebounded. Is that a coincidence, or are they interrelated? If the latter, the recessionary signal from the inverted yield curve is wrong. It’s the latter.

The leading economic index, which has declined sharply over the past year, triggering fears of recession, includes the yield curve. Yield curve inversion has been a significant factor in the decline of the aggregate index over the past year. Yet, is the yield curve still a reliable leading indicator with the creation of QE?

It’s common for the index composition to change from one cycle to the next because economic, financial, or policy changes make some indicators less reliable or obsolete. Broad money failed as an indicator before the Great Financial Recession. A new credit series replaced it in 2012. It will not be surprising if the leading index includes a QE series and removes the yield curve indicator at some point.

It’s worth noting the 2020 recession was unique from the standpoint non-economic factors triggered it. Yet, the monetary and fiscal policymakers viewed it as a vast economic disaster, rightly so, and responded with the most significant monetary and fiscal stimulus ever seen. Doubling the Fed's balance sheet from $4 trillion to over $8 trillion in 18 months was never done before, and we still need to learn all the economic and financial consequences. At the very least, the aggregate stimulus and new ways of interjecting liquidity in the system raise questions over long-trusted indicators such as the yield curve and broad money.

Investors should keep it simple; the economy is growing if companies generate profits and hire.

The Bureau of Economic Analysis’s first guess at real GDP annualized growth in Q1:2023 was a paltry 1.1%. Bear in mind that the BEA does not yet have March 2023 data for business inventories, net exports or construction expenditures. With only full January and February inventories data, the estimated change in real business inventories in Q1 “contributed” minus 2.3% to the annualized percent change in Q1 real GDP. Who knows, perhaps the March inventories data will reduce the magnitude of the drag on real GDP growth from this component.

In contrast to the drag on Q1 real GDP growth from real business inventories, real Personal Consumption Expenditures (PCE) contributed 2.5% to Q1 annualized real GDP growth. At an annualized rate, Q1 real PCE increased 3.7% versus 1.0% in Q4:2022 and the fastest growth in real PCE since the 12.1% recorded in Q2:2021. Given that real PCE accounted for around 71% of real GDP in Q1, the economy seemingly was on fire in Q1, right?

Wrong! Let’s take a look at the behavior of monthly real PCE as compared to its quarterly average. This is shown in Chart 1 below. The blue bars in Chart 1 represent the month-to-month annualized percent changes in real PCE. The red bars represent the quarter-to-quarter annualized percent changes in real PCE. So, the annualized growth of 3.7% in real PCE in Q1:2023 was the result of the outsized 17.6% annualized growth in January 2023 PCE growth. Monthly real PCE contracted in February and March 2023. In fact, real PCE contracted in four of the past five months. It seemed as though a myriad of measures of economic activity were very strong in January, very strong, as a former president might say. Could it have been that January 2023 was uncharacteristically warm?

The Federal Reserve Bank of Philadelphia’s state coincident indexes in March show only one state (Alaska) with a decline from February. West Virginia again had the largest increase: a whopping 1.69 percent (Massachusetts and South Dakota were just shy of 1 percent). At the three-month horizon Alaska was also the only state to see a loss, and West Virginia registered the highest increase, with its 3.91 percent gain about 1 ¾ percentage points above number 2 Montana. A remarkable 26 states had increases above 1 percent. Over the past 12 months, New Mexico was the leader (as was the case in February’s report) with an increase over 5 percent (Florida was barely short. Florida, Nevada, and Texas were the other states with gains above 4 percent. Wyoming, Vermont, and Kansas were the states with increases less than 1 percent over this period.

The independently estimated national figures of growth over the last 3 months (.86 percent) seems short of what the state figures suggest, while the corresponding 12-month result (3.85 percent) looks somewhat higher than what the state results might suggest.

State payrolls were little-changed in March. Only 2 states (Massachusetts and Kentucky) saw statistically significant increases, and a number saw point declines. The largest numerical gain was Texas’s 28,600. The sum of the changes in all the states was a modest 177,300.

18 states saw statistically significant declines in unemployment, none larger than the .3 percentage point drops in New Hampshire, Oregon, and West Virginia. DC experienced a .1 percentage point increase. Nevada continued to have the highest unemployment rate, 5.5 percent. The two Washingtons (DC and the state) were the only other places with unemployment rates as much as a point higher than the national average of 3.5 percent. Alabama, Nebraska, New Hampshire, South Dakota, and Wisconsin were at least a pointer under the national rate, with that n South Dakota an incredible 1.9 percent.

Puerto Rico’s unemployment rate held at 6.0 percent, and its job count was essentially unchanged.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in February were generally up. Only 3 states (Connecticut, Pennsylvania, and Massachusetts) saw declines from January; West Virginia’s 1.11 percent gain was far and away the largest. All states saw increases over the three months since November, with only 3 (New Jersey, New York, and Arkansas) having gains less than .5 percent, and 17 growing more than 1 percent (West Virginia was again on top, with a 2.35 percent increase). Over the past 12 months, New Mexico was the only state with an increase over 5 percent (Florida was barely short, while Texas and California were well over 4 percent)), while Hawaii and Kansas were the only states with gains less than 1 percent.

The independently estimated national figures of growth over the last 3 months (.16 percent) seems a bit short of what the state figures suggest, but the corresponding 12-month result (3.95 percent) looks plausibly in line with those of the states.

State real GDP growth in 2022:Q4 ranged from Texas’s 7.0 percent annual rate to declines in South Dakota, Nebraska, and Iowa. States in the West and South grew more rapidly, while agricultural states, as well as some older industrial states in the Middle West and Northeast, were weaker. Once again, states with large fossil fuel production sectors did well, with both West Virginia and Wyoming joining the oil producers in the top ranks.

State personal income growth rates ranged from Massachusetts’ 15.3 percent to Colorado’s 2.5 percent decline. The Massachusetts number was an artifact of a 76.1 percent rate of increase in transfers, while Colorado saw a 38.5 percent rate of decline in that area (a correction for a freak surge in the third quarter). Growth of “net earnings” (employee compensation plus proprietors’ income) was evener, though Nevada saw a double-digit rate of gain there (Oregon was nearly as strong) while South Dakota eked out a 1.0 percent growth rate.

For the week ending March 15, bank lending to commercial, industrial, real estate, and consumers increased by $40 billion, following a slight increase of $10 billion in the prior week. The two-week increase was more than half the cumulative increase over the previous two months, January and February.

It is far too early to assess the impact of additional changes in lending standards. But the early March lending data reflects the tighter lending standards and the rise in market rates over the past year. And even with those tighter lending and higher rate conditions, the banking system showed a willingness to lend and businesses and consumers an appetite for borrowing.

A bank-driven credit crunch may eventually happen, and investors are betting something substantial will occur, given the sharp drop in yields. But a few things may mitigate its impact, if not limit, its duration.

First, all the top commercial banks are well-capitalized and do not face any liquidity constraints. It is hard to see a broad, deep, and enduring credit crunch that does not involve the top banks.

Second, the Fed's Bank Lending Program should ease mid-tier banks' liquidity issues, and that should limit any pullback in credit due to tighter standards. The program runs for an entire year.

Third, market interest rates have dropped significantly, which could boost the demand for credit.

It is instinctive for investors to rush to buy the safest and most liquid assets, even when there is a hint of a banking crisis. That's the playbook investors have used in prior financial crises. Still, a 125 basis points drop in two-year yields over a few weeks is far bigger than during the early months of the 2007-09 financial crisis. The economic and financial data must support that negative narrative on yields for them to stay.

History has shown that the "price" of credit has been the main rationing factor for credit. And until the "price" of credit gets more expensive through market forces or Fed raising rates, any pullback in credit should prove to be "transitory."

In the wake of the FDIC-mandated closings of Silicon Valley Bank and Signature Bank, deposits at commercial banks have declined a net $161.0 billion in the two weeks ended March 15, 2023 (see Chart 1 below). In that same two-week period, money market funds that invest in US government securities and repurchase agreements collateralized with US government securities experienced a net inflow of $130.8 billion, according to the Investment Company Institute. These money market funds gained another $131.8 billion in the week ended March 22, 2023. Each share in these money market funds is valued at $1 or par. But there is no federal guarantee that these shares are redeemable at par. Yet there were large inflows of monies into these taxable government money market funds at the same time there were large outflows of deposits from commercial banks. Deposits at commercial banks are insured to be payable at par of up to $250 thousand per account ($500 thousand for joint accounts) by the Federal Deposit Insurance Corporation (FDIC). It would seem that the nonbank public has more confidence in the full faith and credit of the US government than the FDIC (unless the federal government is forced to default on its debt because of Congress failing to increase the ceiling on Treasury debt issuance). To the best of my knowledge, no government-only money market fund has ever experienced a decline in its share value below $1. Assuming that the debt ceiling is raised in time to avoid a Treasury default, do we really need federal deposit insurance?