After the last FOMC meeting, I talked about how the risk-reward ratio had tilted in favour of both bonds and stocks. The reasoning was that with the probability of further incremental rate hikes is lower, even in a world where market participants believe the path of lower rates will be delayed, there would be a larger tail risk that we could get softer data and hence less of a delay. That indeed has played out over the past week, where a number of U.S. indicators have come in below street consensus, but not distressingly so.

 

I mentioned some of these on this week’s conference call, but let’s start with the consumer. Upward trending unemployment insurance claims alongside a moderation in payrolls growth in April have played out in terms of a decrease in consumer confidence. The preliminary University of Michigan sentiment index for May came in at 67.4 compared with an April reading of 77.2 and expectations of only a slight pullback. This extends the deterioration in consumer confidence that started in January and April’s drop in the Conference Board measure to 97.0 from 103.1 in March lines up with what we saw in this week’s retail sales data.

 

 

The decline of 0.3% in the retail sales control group (excluding autos, gasoline, building materials and food services) was the complete opposite of what economists had predicted and creates a negative base effect for the second quarter. Consumer credit also grew by a slower rate of $6.3 billion in March, likely a response to a lack of interest rate relief. In terms of how the labour market looks going into the summer, there has been an upward trend in jobless claims and the latest business surveys would suggest a cooler climate ahead.

 

The Philadelphia Fed index for May came in at just 4.5 from a level of 15.5 in April and the Empire State business conditions index remained in negative territory this month. The broader Institute for Supply Management (ISM) indexes have also moved back below the breakeven (50) mark – both manufacturing and non-manufacturing.

 

Again, these reports are indicative of a slowing and not cratering, which is exactly what the market wants. Cool enough to nudge inflation lower and open the door to Fed easing, but not too cold that companies begin to see pain on the income statement.

 

 

This earnings season has largely been ahead of expectations on both revenues and profits, although only 59% of S&P500 companies have come in ahead on revenues, compared with close to 80% beating on earnings. Given the attention to margins by companies in the wake of higher rates, input costs, and wages, coupled with slower nominal economic growth, it is not surprising that we are seeing such a divergence. Home Depot is a good example of this. Last quarter saw earnings that beat analyst expectations, but same-store growth looked lackluster. That might change if we get a strong summer season, but it might also reflect spending fatigue among consumers. This thesis was also reflected in McDonalds latest results, where revenue growth was roughly in line with estimates but industry traffic was weakening. Not only that, consumers were becoming more selective when it came to price for value and this was mainly in the lower income segment of the customer base.

 

Bucking the trend, Walmart’s recent quarter came in ahead of estimates on both revenue and earnings, but offered guidance for the next quarter that was also above street consensus. Sounds great so far and some analysts have raised their targets, but there was an interesting observation under the hood. Most of the growth last quarter came from upper-income households according to management. Now this isn’t the first time we have seen this, but it is clear that consumers in all income categories are looking for value and not behaving as they did out of the pandemic. In other words, there is more discretion even in non-discretionary spending.

 

 

The so-called cascading of consumer spending down the value chain is a moderate form of rationalizing and may stem from a longer period of high borrowing costs. It seems pretty intuitive how this fits into the Goldilocks narrative. Aggregate consumer demand growth is slowing or turning negative, which leads to less pricing power for retailers and then ultimately less increases in prices (or declines). The problem is that goods aren’t driving inflation anyway. Shelter costs, gasoline and insurance are mainly the reason we aren’t in 2% area right now.

 

Motor vehicle insurance costs were 22.6% higher in April than a year ago. The cost of caring for the elderly and those who need enhanced care at home was 13.9% above last year’s levels and shelter costs (rent, lodging away from home and owners’ equivalent rent) were up 5.5%. The insurance cost inflation is coming mainly from higher prices for vehicles, which should calm down in a slowing demand environment. As for home care, the largest annual price increases on record have stemmed from worker shortages and sharply higher wages. As the general demand-supply imbalance in the labour market normalizes, this pace of inflation should also moderate in my opinion. That leaves shelter. Well, as much as 5.5% is high and this component does represent 36% of the overall CPI index, this is a large improvement from 8% at this time last year.

 

The Federal Reserve would be the first to agree that interest rates are going to have little direct impact on any of these inflation drivers, especially home care. That is exactly the reason why it might be inclined to start trimming rates sooner than later. In other words, rather than wait for absolute proof that inflation is back to its 2% target, which risks overshooting and potentially pushing the economy into recession, why not deliver a couple of insurance rate cuts now and see what happens. That has been Ally’s and my view since the start of the year and it holds today. Whether those cuts start in July or September, they are going to be constructive for bonds and equities up until the time when election anxiety dominates fundamentals.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful long weekend.   

Andrew Pyle

 

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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

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