September 28, 2023
The Need for Speed
Tim Urbanowicz, CFA
Head of Research & Investment Strategy
Innovator Capital Management
One of the tasks I’m responsible for in our home is signing the kids up for the various sports they want to participate in. Baseball in the spring, soccer in the fall, basketball in the winter. What I learned the hard way is these sports are popular and space is very limited! When it’s time to sign them up, I had better do it quickly or they go straight to the waitlist. Explaining why the kids may not be able to play with all their friends, whose parents were on top of it, is not fun. Speed matters.
When it comes to the present U.S. economy, speed is also very important. After a spike all the way up to 9.1% at the end of June of last year1, CPI clocked in at 3.7% at the end of August2. Data is heading in the right direction…that’s good news. Looking at the labor market, job openings are declining and the quit rate is falling. Also, good news. In current form, however, the transition to interest rate cuts still looks a long way off. While the data is moving in the right direction, it’s going very slow. Especially the labor market, where we desperately need to see some softening.
The focus at the next several Fed meetings will continue to be the need for another 0.25% hike, not whether or not it’s time to cut. The real question now becomes, how long can the economy stomach higher rates and avoid any major damage? Up to this point, rate hikes have been digested very well. Consumers and corporations have brushed the burst from 0%-5.5%3, as if it were nothing. The longer we go, however, the less and less likely that is to be the case. Speed is important.
In this month’s newsletter, we dive into why, if speed is in the cards, and ideas for how investors can position portfolios heading into year end.
Consumers in good shape... but maybe not for long
Consumers have single handily kept the U.S. economy afloat, fighting off recession calls left and right. The August spending print was the highest since October of 20214, well above expectations and very resilient. However, signs of fatigue are starting to show up.
Excess savings accumulated throughout the pandemic has played a significant role in keeping spending robust. As shown below, savings has seen a steady drain since 2020, supportive of consumer spending habits. At the end of July, the savings rate was down to 3.5% and on the current pace, excess savings is set to be completely exhausted by the end of October5. The dry powder is drying up.
Source: Bloomberg LP, US Personal Savings as a % of Disposable Income, as of 7/31/2013 – 7/31/2023
With savings on its way down, consumer debt is on its way up. Household debt rose $16B in the second quarter alone6, pushing household debt up to a record $17.1T7. The standout story, however, was credit card debt. Credit card debt exploded $45B8 and eclipsed $1T9 for the first time in history. Bad debt on a bad trajectory.
Source: New York Fed, FRBNY Consumer Credit Panel/Equifax
And finally, let’s not forget, student loan repayments resume in October (see light blue in chart above). While there is some flexibility with the restart, the average monthly payment is around $50010. That’s not insignificant, and will add to the strain. More dollars will be going to debt payments, and less to goods and services.
While higher rates have had a minimal impact on consumers, we can’t expect that to continue forever.
Corporate Debt Coming Due
Similar to individuals, corporations have been fairly well insulated from higher interest rates, as only 6.5% of S&P 500 debt is floating rate11. As time goes on, however, debt will come due and need to be refinanced at current market rates. And at present, that is a big gap. As shown in the chart below, the spread between the average coupon of S&P 500 debt and the current yield to worst on current debt, is hovering around the widest gap we have ever seen.
Source: Bloomberg LP, Bloomberg US Agg Corporate Yield to Worst, S&P US Investment Grade Corporate Bond Index Average Coupon, as of 12/31/1999 – 8/31/2023
There are over 4,200 bonds that will mature between 2023 and 202512. Excluding financials, that figure drops significantly, but still, between 2024 and 2025, 14% of S&P 500 ex-financials debt will be coming due13. I have seen several commentaries downplaying this figure as a non-issue, but that is not insignificant by any stretch of the imagination, especially given the gap between current yields and coupons.
Source: Bloomberg LP, Innovator Investment Strategy & Research, 1/1/2023 – 12/31/2035
Bottom line, just like consumers, corporations need rates need to come down quickly, or risk a shock to many capital structures.
Is Speed in the Cards?
The amount of time it is going to take to get to rate cuts will be most dependent on the labor market. Wages drive consumption, and consumption drives inflation. Can wages slow quickly enough to turn the Fed from hawkish to dovish?
It’s not ideal to see headlines of airline pilots and UPS drivers getting 40-50%+ raises over the next several years, or the various union strikes that are taking place. On the positive side, several leading indicators point to softening. Specifically, the quit rate is trending down, and this tends to be a strong indicator for future wage inflation (i.e. less people feeling secure leaving their current employer, less large pay increases for jumping ship etc.). The bad news is that wage inflation tends to lag the quit rate by about a year, as shown below. The softening in the labor market that we desperately need is going to take time.
Source: Bloomberg LP, JOLTQUIS Index, Bureau of Labor Statistics, Atlanta Federal Reserve, as of 12/31/2004 – 7/31/2023
For the Portfolio
All in all, it could be a slower process - one that allows the sting of higher rates to have more of an impact than investors are pricing in at the moment. To say equity market gains have been robust in 2023, given the backdrop, is an understatement. I believe looking to strategies that can lock in and protect these gains is prudent. The sting of higher rates has been subtle to date, but the longer we go, the harder the hit is likely to be and we don’t want to be caught flat footed.
Tim Urbanowicz is VP of Research & Strategy at Innovator. This material contains the current research and opinions of Tim Urbanowicz, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. The user of this information assumes the entire risk of any use made of the information provided herein. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of Innovator ETFs or any of its affiliates.
The Consumer Price Index, or CPI, measures the overall change in consumer prices based on a representative basket of goods and services over time.
1. Bloomberg LP, US Consumer Price Index, 8/31/2023
2. Bloomberg LP, US Consumer Price Index, 8/31/2023
3. Bloomberg LP, US Federal Funds Rate, 8/31/2023
4. Bloomberg LP, US Core PCE Index, 8/31/2023
5. Bloomberg LP, US Personal Savings, 8/31/2023
6. New York Fed, FRBNY, Consumer Credit Panel, Equifax, 6/30/2023
7. New York Fed, FRBNY, Consumer Credit Panel, Equifax , 6/30/2023
8. New York Fed, FRBNY, Consumer Credit Panel, Equifax , 6/30/2023
9. New York Fed, FRBNY, Consumer Credit Panel, Equifax, 6/30/2023
10. New York Fed, FRBNY, Consumer Credit Panel, Equifax, 6/30/2023
11. Bloomberg LP, S&P 500 Index, 8/31/2023
12. Bloomberg LP, 8/31/2023
13. Bloomberg LP, S&P 500 Index ex-financials, 8/31/2023