As we turn the corner to the 4th quarter, it’s becoming even more pronounced that the US Economy continues to run at two speeds.
We have high-income households and cash-rich companies with low debt that benefit from higher interest rates on their savings plus asset growth. The mega-cap companies, which are riding the tailwind from AI spend also have operational leverage that small and mid-cap companies do not. This part of the Economy is riding high and carrying the weight.
The other side of the coin is the part of the Economy plagued by higher rates and inflation: Consumers who carry high-interest rate debt haven’t benefited from asset growth and are reeling from the effects of inflation. Commercial real estate has been impacted by a post-Covid new normal in office and higher rates to refinance into. Small businesses that require floating rate debt and limited operational leverage, having a difficult time passing off higher prices to their customers, are in very different shape than their mega-cap brethren. Small business confidence is as low as we’ve seen in decades.
Put differently, the Fed’s rate rising cycle / policy was tight enough to squeeze low-end consumers and smaller businesses, but it also resulted in excess liquidity being generated into the pockets of high-end consumers via higher asset prices and investment income.
A great example of these 2 speeds of the Economy is earnings.
The large-cap S&P 500 that has seen earnings growth of +10% since 2021.
The complete opposite is the small-cap 600 index, which has seen no earnings growth since 2021. In fact, it is down around -30%.
Multiple Expansion
On one hand, we have had some classic recession indicators like an inverted yield curve that has steepened of late, LEI’s (leading economic indicators) which flashed contraction for the better part of the last year, and a nationwide unemployment rate that rose from 3.4% to 4.2%, then add in manufacturing which has been in contraction for the better part of 2 years. These classical inputs have been more apt to hit small businesses, low and middle-income households and the cyclical parts of the Economy. They have not registered in any meaningful widespread slowdown elsewhere thus far.
On the other hand, confidence is building in the other parts of the Economy that a slowdown or recession won’t show up, mainly the top of the capitalization structure is pushing market prices higher than fundamentals at the moment. As shown below, earnings are continuing to grow for the large-cap companies, which is great and exactly what is wanted. However, the Market is outpacing that earnings growth and being pushed by what we call multiple expansion.
Multiple expansion makes the Market more expensive. We started 2024 trading at 21.4x Earnings on the S&P 500. Today, given the Market move, we are trading at 24.4x earnings. A lot of confidence is being built that these parts of the Market are immune from anything. This concerns us for forward returns due to these lofty valuations.
Fiscal Dominance
Our interpretation of this fragmented or bumpy Economy is that recessions look different during periods of fiscal dominance. What do we mean by fiscal dominance? Well, we’ve been running 6% of GDP deficits during maximum employment over the past few years. To put that in perspective, that is approximately $1.5-2.0 Trillion above pre-Covid trend in additional government spending annually.
We’ve essentially been pre-stimulating before any recession fully emerges. Another way to visualize it is last month’s jobs report, which showed solid payroll growth. Net jobs were created from the non-cyclical part of employment: Government & Healthcare. The rest of the industries together reported net job losses. The fiscal dominance is impacting the structural employment backdrop as well at the moment.
We expect this fiscal dominance to continue as both political candidates at the moment have outlined policies that will continue the runway during their terms.
The chart below depicts the fiscal dominance quite well. US total debt outstanding has risen 52% since Covid to nearly $36 Trillion, causing net interest on the debt to jump to $1.1 Trillion a year.
The Fed just lowered rates by 50 bps at the September meeting. Contrary to what many were expecting, Treasury Yields have risen +0.35% since that day, as shown on the chart below.
A combination of a multitude of factors are converging at the moment: higher debt levels to continue to service, a bifurcated Economy that doesn’t show signs of recessing near-term, inflation components at risk of moving higher again as the Fed is back to easing monetary policy, has the Bond Market moving against the Fed (yields up).
Higher rates could pressure multiples coming off a year of multiple expansion. This is what we will be paying close attention to as we head into the home stretch of 2024.
Mike Harris
