On The Road Again – August 18, 2023

Wealth Management • Aug 19 2023
On The Road Again – August 18, 2023
Morgan Lewis Posted on August 19, 2023

On The Road Again

Just like Willie Nelson, this week HAI is on the road again. Amid cross-country travel, this week’s commentary will be brief and to the point.

The latest update of the Conference Board’s Leading Economic Index (LEI), out this week, moved even further into what are already deeply recessionary levels of contraction with a very notable 0.4% month-over-month decline. This is the 16th straight month (the longest such streak since the great financial crisis) of decline. As last week’s HAI highlighted and underscored, the leading indicators do indeed lead with mechanical precision. Coincident, real-time economic data tells us where we are. The leading data speaks of where we’re headed. On this point history is unambiguous. As of this week’s update, the leading economic data continues to paint a portrait of hard landing recession, and its timing is too close for comfort.

Still, as the soft-landing narrative has gained considerable traction over recent months, consumer sentiment has improved. Since the all-time sentiment lows registered in 2022, lower inflation prints, a rising stock market, and vocal (if premature) optimism over the economic outlook have all contributed to a bounce in consumer sentiment measures. If we take a deeper dive into that consumer sentiment improvement, however, the details offer precious little comfort. 

Lower- and middle-income earners reflect a more positive outlook of late. That’s certainly a positive, but, importantly, earners in the top tercile of the income ladder are not confirming the “all clear,” nor are they jumping on the soft-landing bandwagon. This all-important cohort—top income earners—tends to consist of business owners and/or executives. Sentiment among these business leaders, rather than floating along with the stock market breeze, is a more determined, evidence-based assessment. 

At present, continued weak sentiment measures among top earners is broadcasting a significant insight. Ongoing weakness in top tercile consumer sentiment informs us that business owners and top executives are aware of what has become a glaring and growing difficulty throughout the corporate universe—collections on Accounts Receivable.

This disturbing development has been flagged by the latest National Association of Credit Management (NACM). NACM’s Dollar Amount Beyond Terms has now slid to its worst level, outside of pandemic lockdown, since the great financial crisis era. Until corporate executives, the group responsible for hiring and firing decisions in our economy, can see already recessionary and rising levels of “Past Due Collections” begin to drop, they’re not likely to adopt the soft-landing narrative. 

That’s important. As long as the number of past due collections heads north, especially as truly atrocious labor productivity heads south, executives will keep an increasingly itchy finger on the job-cut trigger. When push comes to shove, unless dynamics improve meaningfully, they will gradually cut staff. As long as executives have cause for concern, the labor market—and by extension broad consumer sentiment—will remain at risk. If executives cut jobs, the consumer will crack. If the consumer cracks in a 70% consumer-driven economy, you’ll lose both the economy and the stock market.

Another indication of economic stress is that business owners and insiders aren’t buying stock in their own companies. Currently, “insider buying” in the S&P 500 stands at a paltry 12%—the lowest level in over a decade. The chilling figure conjures the old wisdom of “watch what they do, not what they say.” All in all, at present, owners and corporate executives are expressing an informed caution—a caution historically reserved for times when the economy is on the precipice of recession.

Last week also offered us another subtle clue that the recent banking turmoil isn’t over. Ratings agency Moody’s warned that the banking sector shouldn’t be so “out of sight and out of mind.” Moody’s downgraded their ratings of 10 U.S. banks and placed another five under review for potential future downgrades. The downgrades and outlook warnings indicate ongoing strains and mounting concern over building, unresolved pressures in the banking industry despite current investor complacency.

Banks have been forced to pay more for deposits than they are making back in earnings growth from loans. While the soft-landing party rages on, falling margins at banks have negatively affected credit metrics and bank fundamentals. As Moody’s highlights, banking system vulnerabilities lead directly to financial system vulnerabilities. Among the banks impacted by the downgrades and rating reviews are U.S. Bank, Fifth Third, Capital One, PNC, M&T Bank, Pinnacle Financial, BOK Financial, Webster Financial, Bank of New York Mellon, State Street, and Northern Trust. Moody’s said that U.S. banks face continued risks “as the wind-down of unconventional monetary policy drains systemwide deposits and higher interest rates depress the value of fixed-rate assets.”

Moody’s now predicts a 2024 recession, and believes the quality of bank assets will decline as “rising funding costs and declining income metrics will erode profitability, the first buffer against losses.” Moody’s continued, “Asset risk is rising, in particular for small and midsize banks with large CRE exposures.” 

That last bit about commercial real estate is key. Perhaps Moody’s has noticed what is quickly becoming a very dangerous trend affecting banks’ commercial real estate exposure, particularly in office CRE exposure. Take note of an important trend; a year ago CRE office delinquency rates were 1.62%, six months ago they were 1.86%. Since then, May’s delinquency rate spiked to 4.02%, June’s hit 4.5%, and July jumped to 4.96%. HAI, along with Moody’s, apparently, spots an important and disconcerting trend.

Cautious business owners and executives, along with growing bank pressures that act to further constrain bank lending and intensify the incoming credit crunch, will certainly not help to improve the soft-landing odds. History may not always repeat, but it rhymes with enough logical consistency to keep us mighty cautious and vigilant. As ever, we look for the risks. They are very high at present, but we also look for the opportunities that naturally present themselves amid those risks. Select hard assets, precious metals, and deeply undervalued related producers offer just such a building opportunity at present. 

Value investing isn’t for the faint of heart. It’s notoriously challenging, and typically pays out only on its own timeline. That said, history is also clear that value investing does indeed pay. It’s much like the lottery: when it pays, it pays big and all at once. Just as with the leading economic indicators, when value investing, it’s best to focus not on where we are, but on where we are going. HAI maintains that the future holds a stark rerating higher for the value sector that is hard assets. Risk, but equally opportunity, abounds. The road ahead for hard assets is prosperous and bright. In the meantime, we wait for the economic and Fed cycles to shift. We’re now rapidly nearing the point at which, concerning prosperity, hard assets are certain to be—on the road again.

Weekly performance: The S&P 500 dropped 2.11%. Gold was off 1.55% while silver was nearly flat, down 0.04%. Platinum was also nearly flat, up 0.04%, and palladium was down 3.75%. The HUI gold miners index was drubbed, down 6.28%. The IFRA iShares US Infrastructure ETF was down 2.26%. Energy commodities were volatile and lower on the week. WTI crude oil was off 3.04%, and natural gas dropped 7.91%. The CRB Commodity Index was lower by 1.52%, while copper was down 0.27%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 3.60%, while the Vanguard Utilities ETF was down 2.04%. The dollar index gained 0.57% to close the week at 103.28. The yield on the 10-yr Treasury was up 10 bps to end the week at 4.26%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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