Every cloud has a silver lining

From my days as a kid growing up in the streets of Newark, my Mom and Dad taught me that “every cloud has a silver lining—you just have to find it.” In that spirit, with the usual set of August thunderclouds looming in what is traditionally a weak time for markets, I thought it might be helpful to point to some silver linings that we at Federated Hermes see emerging ahead, even as the bad news plays out. 

Among the concerns I’ve heard of late, five strike me as particularly in focus: China’s real estate bubble appears to be bursting; Powell’s Jackson Hole speech is likely to be hawkish; next week's Nvidia results are unlikely to beat lofty expectations; student loan repayments start soon; and pent-up savings from the Covid lockdowns are evaporating. As with most worries on the Worry Wall, all five have substance to them, and my guess, are likely to occur to some degree. However, while the market knows about them and to a certain extent has discounted them, what I see as less in focus and therefore a potential offsetting positive, are the silver linings. We’ve pointed to these in our last two market memos, “10 reasons the market’s glass could be half full, not half empty” and “Rocky landing landing”; let’s take a fresh look in light of the five looming thunderclouds.

• China’s real estate bubble burst is getting worse—more stimulus probably on the way even as Chinese deflation helps the global inflation picture. Over the last week or so, global investors have watched anxiously as the economic news out of China worsens. First, a second large real estate developer, Country Garden, missed a bond payment on the back of continued real estate sector weakness. Then this week came news of a bank run of sorts on a non-bank fund with overexposure to the real estate space. No doubt, China has disappointed this year and may even have entered a secular relative decline given the trend toward global re-sourcing and its well flagged demographic issues. This said, there are some offsets that we think make this news less worse than the consensus thinks. For one, the deflation underway in China, as its exporters scramble to regain lost market share, should begin to help the U.S. and Europe combat their ongoing inflation problems. And second, with social unrest potentially looming as its crisis spreads, we’d expect the government, as usual, to unlock new stimulus measures that should be market friendly. (With $3.2 trillion in foreign currency reserves, it’s not like they don’t have any firepower left!) None of this may be terrific, but with China’s flagship internet retailer down 70% from its 2020 highs and trading at a single-digit P/E multiple, it would seem an awful lot of bad news has already been priced in.
• Powell seems likely to amp up the hawkish commentary at Jackson Hole—keeping everyone else, helpfully, cautious. Many are worried that given the continued strong U.S. GDP numbers, along with historically low unemployment, Fed Chair Jay Powell will use next week’s Jackson Hole speech to reiterate his ongoing concerns about inflation. Bring it on, we say! One risk for the Fed of now arriving so close to its inflation target (the most recent data has monthly core inflation running somewhere between 2.5% and 3.6% on a 3-month basis) is that the bond market gets ahead of it and restimulates the economy with a big shift down in yields. Already, bonds are pricing in three Fed cuts in 2024, and a too dovish update next week could bump rate cut expectations even higher. Powell is on to this, and unlikely in our view to surrender hard won credibility gains of the past year with a premature shift back to policy looseness. On the other hand, with inflation clearly in decline and the deflationary pressures now looming from China, it will be hard for Powell to credibly appear too hawkish. And importantly, the more hawkish Powell remains, the more cautious business managers and even labor union leaders will behave, keeping inflation trends positive. Net net, we expect Jackson Hole to be a non-event, and given the concerns leading into it, this itself might be enough to spark a rally.
• Nvidia seems unlikely to beat over-hyped expectations—feeding the fuel that has already begun the needed broadening in the market. The first-half rally was fueled for sure by the increasingly real prospects for artificial intelligence (AI). The push to ramp up in AI finally ended the tech bear market that had begun 18 months earlier, and AI chip maker Nvidia for sure has been the leader of this charge. We are no experts on Nvidia, but given how hyped expectations are for the quarter, our guess is that beating them may be difficult. If they miss, the market could very likely hit another speed bump. Or—money might rotate into other stocks. As readers of this space know, our view on the back half of this year has been that the market is most likely to broaden out from the very narrow first half leadership from the “Magnificent Seven,” all mega-cap tech stocks. As recession fears recede, better 2024 earnings come into focus and risk appetites return, it seems likely to us that investor funds rotate into the broader market, which is significantly cheaper than the big tech leaders and likely to see the most significant earnings bounce in the next two quarters. Less than perfect earnings out of Nvidia, rather than dragging the whole market down with it, could catalyze the rotation that is already underway.
• Student loan repayments are about to start—tempering growth pressures but not nearly offsetting the positive impact of broad job and wage growth. Nearly every Wall Street strategist I meet with these days, when pressed to identify the catalyst for the recession that is expected later this year, points to the student loan time bomb, where temporarily deferred interest payments are slated to restart in October. While we are impressed for sure with the $1.57 trillion size of student loan debt, it strikes us as a bit myopic to focus only on this factor without considering other forces that simultaneously are turning positive and more than offset the negative forces coming from loan repayments. Let’s do the math. The upcoming loan repayments in Q4 are anticipated to be $15 billion, or about $400 a month among borrowers with outstanding loans. But against the run rate of nominal GDP, Strategas Research estimates the negative drag would only amount to two-tenths of a point over 12 months. Meanwhile, every day that the much anticipated recession’s start gets delayed, more jobs are added to the economy, and more workers enjoy pay raises. For example, year-to-date through July, the U.S. economy has added 1.8 million new jobs and, together with wage increases, COLA adjustments on Social Security and other reflation-linked income increases, consumer income is up $860 billion annualized, 3.2% of GDP. That will certainly more than offset the drag from student loan repayments.
• Consumers’ excess savings balances are declining—but consumer net interest expense is still far below its pre-Covid highs. Another catalyst for the recession that hasn’t come was supposed to be the diminishment of consumers’ pent-up savings from the Covid lockdowns. On most numbers, that savings level has dropped from $2.3 trillion at its high to $120 billion today. This along with rising consumer debt, the story goes, will spark a recession. Let’s slow down and do the math again. Though consumer savings are down, because the Fed has hiked the interest rates that consumers earn on those savings, the interest income from the savings pool has gone up, not down. And because most consumers wisely refinanced their long-term mortgages at fixed low rates during the lockdowns, consumer net interest expense is still LOWER than its pre-Covid levels. For instance, total net household debt service payments relative to disposable income, according to the St. Louis Fed, today sits at 9.6%, far lower than where it stood in late 2007 prior to the mortgage crisis (13.2%) and even lower than what it was before the current Covid/post Covid cycle started in late 2019 (9.8%). So, while debt levels are bit higher, with 60% or so of those debts represented by long-term fixed-rate mortgages, consumer finances are actually in better shape than they were when the market was considerably above present levels.

And here’s one last bonus thought. Despite all the above, most economists are still predicting a moderate recession at some point, even as it gets pushed out further into 2024. While this is interesting, every day that goes by without one, the nominal size of the U.S. economy marches ever higher. Today, nominal GDP is running at $26.8 trillion annualized, a solid $2.48 trillion higher than 2021, when the S&P 500 peaked at 4,800 and forward earnings for the next year would reach $219. By 2024, nominal GDP, even using the consensus number, is forecast at $28.5 trillion, up 17% from 2021. News flash: stocks eat nominal GDP. In this light, our $250 earnings forecast for 2024 does not seem ambitious at all.

So, while we too can see some storm clouds on the horizon, we also see rays of silver lining them. Should we get a deeper pullback in August’s coming dog days, we’ll be looking to add further to our existing equity overweights. Stay tuned.