Latest Economic Review: Sunpointe Illuminations

November 2023

Despite strong Q3 GDP growth, we may finally be seeing cracks in the economy/labor markets

Labor markets may finally be showing signs of cooling based on October’s below expectations report and downward revisions to reports from August and September. U.S. employers added 150,000 new jobs to the economy last month, below the 170,000 estimate and trend for most of 2023. The unemployment rate of 3.9% jumped more than anticipated and the broader U6 unemployment rate increased to 7.2%. Average hourly earnings, a key measure for inflation, increased 0.2% for the month, less than the 0.3% forecast, while the 4.1% year-over-year (Y/Y) gain was 0.1 percentage point above expectations. While the healthcare sector added 58,000 new jobs in October, the manufacturing sector shed 35,000 jobs, mostly coming from the UAW strike. The August and September reports were revised lower by a combined 101,000.

The U.S. economy grew at a better-than-expected rate of 4.9% in Q3, up from a 2.1% pace in Q2. Consumer spending, as measured by personal consumption expenditures, increased 4.0% for the quarter after rising just 0.8% in Q2, and was responsible for 2.7% of the total GDP increase. Inventories contributed 1.3%. Gross private domestic investment surged 8.4% and government spending and investment jumped 4.6%. Inventory gains are likely a one-time event and signs of slowing by consumers and businesses may negatively impact Q4 growth. Q4 GDP estimates are currently in the 1.5-2.0% range.

Manufacturing activity in the U.S. slowed further in October based on the ISM Manufacturing PMI. The headline reading of 46.7 was down from 49.0 in September. New orders, production, and employment all slowed last month. The ISM Services PMI also declined in October led by slower growth in production and employment. New orders firmed up and prices remained flat.

Source: Bloomberg, Apollo

After weakness all year, earnings and small caps finally rebound!

After three consecutive quarters of declining earnings in the S&P 500, growth has returned to the flagship benchmark through 80% of the reporting season. Analysts expected little to no earnings growth during Q3, but the aggregate growth rate has been 3.7%. Revenues have increased 2.3% in Q3 and companies missing earnings estimates are being punished more than expected. Earnings are forecast to grow 3.9% in Q4 and 11.9% in 2024. The drivers of better-than-expected Q3 earnings have been communication services, consumer discretionary, financials, and technology. Healthcare has posted weaker than expected earnings in Q3.

The surge and subsequent fall in interest rates over the past six weeks has been rather significant with some significant daily moves in the Bloomberg Aggregate Index. While the Fed is largely finished with its current rate hiking cycle, interest rate sensitive assets like small caps have seen a surge in volatility. Small caps finally bounced upwards in early November, easily outperforming the S&P 500.  While seasonal trends could be in play, the move lower in bond yields was a tailwind for smaller companies. Compared to large caps, small caps as a broad group have significantly more leverage than their larger counterparts, making them more vulnerable to higher interest rates. If the interest rate momentum continues to unwind, small caps may finish the year on a strong note.

Eurozone continues to falter in Q4

Economic conditions in the eurozone continue to worsen. Manufacturing has been in a slump for 16 months, services for three, and both PMI headline indices fell again last month. In addition, all sub-indices point consistently downwards with only a few exceptions. Overall, this points to another lackluster quarter, and a mild recession in the eurozone in the second half of this year with two back-to-back quarters of negative growth would not be a surprise.  According to Eurostat, eurozone GDP fell by 0.1% in Q3, slightly worse than expectations. This highlights how Europe’s economy is being held back by high interest rates, the cost-of-living crisis, and weaker demand from the global economy. Belgium, Spain, and France posted growth while Ireland, Austria, and Germany posted negative results.

China’s economic recovery remains bumpy; more stimulus is needed

China’s economic recovery continues to be bumpy with more calls for government stimulus. The official manufacturing PMI dropped to 49.5 in October from 50.2 in September. The non-manufacturing PMI, which covers the services and construction industries, fell to 50.6 this month, the lowest level since China lifted its Covid-19 restrictions in December 2022. China’s economy is grappling with mounting challenges, ranging from weak consumer spending and a deepening property crisis to subdued global demand. The unexpected decline of the manufacturing PMI shows the recovery in China faces challenges from weak domestic demand. Manufacturing accounts for ~28% of Chinese GDP. The drop in the non-manufacturing PMI suggests that the pent-up demand for travel and gatherings diminished quickly after the Golden Week holiday.

Chinese policymakers have unveiled a raft of measures after a rapid loss of economic momentum following a brief post-COVID rebound, including modest interest rate cuts, increased cash injections, and more aggressive fiscal stimulus.  Additional reserve requirement ratio cuts may be necessary in the coming months along with a potential lift to the budget deficit target of 3% for more stimulus. The IMF recently cuts its forecast for Chinese growth in 2023 by 0.2% (to 5.0%) and 2024 by 0.3% (to 4.2%). The IMF cited the country’s property crisis and weak external demand. The IMF also indicated that growth projections could be cut by as much as 1.6% if the property crisis deepens further.

Worrisome debt trends in the U.S.; will higher rates crush the U.S. economy?

The New York Fed posted some worrisome data points on surging credit card, auto loans. and student loan debt. U.S. credit card debt topped $1.08 trillion according to the NY Fed, up $154 billion Y/Y, the highest annual increase since 1999. Credit card delinquency rates also rose, especially within millennials. The average annual percentage rate for credit cards is now more than 20%, also an all-time high. Overall household debt has increased to $17.3 trillion, with student loan debt and auto loans both at $1.6 trillion. Recent data suggest that nearly 60% of Americans are living paycheck to paycheck and 70% are regularly stressed about finances. This is the result of persistent inflation and 11 rate hikes from the Fed.

Recoveries for high yield bonds and floating rate loans over the last 12 months are 19.6% and 39.7%, well below their 25-year and 24-year annual averages of 40.2% and 64.3%, respectively. This is according to a recent research report from JP Morgan. Whether in public or private debt markets, recovery rates are an essential factor in the overall return investors can hope to achieve. The combination of higher default rates in riskier credit and lower recovery rates could spell trouble in the future. Higher rates will squeeze margins and profitability at highly levered companies, and the result may be an inability to cover interest payments and ultimately a default and/or bankruptcy. Lower recovery rates means there is less available for creditors following a bankruptcy. CLOs could be at risk from lower recoveries.

Source: Federal Reserve Bank of New York

The charts and information in this presentation are for illustrative purposes only, and are based upon sources of information that Sunpointe, LLC generally considers reliable, however we cannot guarantee, nor have we verified, the accuracy of such independent market information. The charts and information, and the sources utilized in the compilation thereof, are subjective in nature and open to interpretation. FOR USE WITH INSTITUTIONAL INVESTORS AND INVESTMENT PROFESSIONALS ONLY. NOT FOR PUBLIC DISTRIBUTION. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.