Dr. John Rutledge
Corrected August PCE 1.6%. Springtime in New York. Things That are Not a Thing
Dr. John Rutledge
Chief Investment Strategist
Summary: Corrected August PCE inflation was 1.6%, not 2.5%—Fed needs to keep cutting. Spring is in the air in New York—commercial real estate moguls I met with this week are sharpening their knives for later this year when they expect thawing credit markets to spike foreclosures and discount sales. First few of my “things that are not a thing.” Please use the Comments button help me add more.
Corrected PCE Inflation 1.6%
In my last post, I explained that the corrected August 12 month CPI inflation rate, after removing Owners’ Equivalent Rent (OER), was just 1.4%, not the 2.5% in the official report. Making the same correction for OER bias to the Fed’s favorite inflation measure, PCE, in this week’s August Personal Income and Outlays report reduces August inflation from 2.5% to just 1.6%. Corrected PCE inflation has averaged 1.6% over the past 3 months—past time to start cutting rates.
Spring is in the Air
My calendar tells me it is the first week of October, but there is a whiff of springtime in the air—maybe even two whiffs! I’m in New York at Safanad this week having conversations with an extraordinary lineup of private equity, credit, and commercial real estate investors. Now that the Fed has changed directions and interest rates will be heading lower for at least the next two years, the best investors are starting to think about how to position their portfolios for the eventual thawing of the credit market and associated turnaround of commercial real estate that is already starting to happen.
That counts on rates continuing to decline, of course, but I think that is a safe bet. The Fed waited too long to start cutting rates but surprised me when they chopped 50 basis points off the Fed funds rate last week. (I didn’t think they had the nerve—or the good sense—to do it.)
The cut will help floating rate borrowers to some degree but will reduce the incomes of the people who own our $6.5 trillion in Money Market funds by $32 billion per month, which almost exactly erases the $34.2 billion increase in disposable income for the month of August, so don’t look for a jump in economic activity just yet.
The fact that bond yields went up, not down, tells us that 50 basis points wasn’t enough. They need to do another 50 right away and another 100 as soon as they have time to hike up their pants again. We need 3% interest rates, not 5% rates, to bring bond yields down enough to rejuvenate the underwater assets on regional bank balance sheets and get the credit markets open for business again.
This week’s employment reports told us that economic activity is doing well, but it will do even better when rates drop below 4% next year on their way to 3%.
Make no mistake—credit markets are still closed for small business customers of regional banks. Bank commercial and industrial loans—$2779 on September 18—billion were $21 billion lower than they were 21 months ago, in January 2023.
IMHO. the ADP report is the best employment metric
That explains why this week’s ADP report showed that in September, even though total job gains (+143K) were strong, businesses with less than 50 employees lost 8000 jobs.
Today’s Employment Report confirmed ADP’s strong job growth story. Nonfarm payrolls added +254K jobs in September and July/August were revised upward by +72K, amounting to +326K total new jobs against a +203K average over the past year.
Strong job growth, falling interest rates, and a thawing credit market are all good for investors as long as they don’t give the Fed an excuse to delay rate cuts. As credit markets thaw out, there will be some interesting opportunities in small cap stocks, in credit, and in commercial property.
Today, many regional and community banks are in “extend and pretend” mode (also known as “a rolling loan gathers no loss.”) By extending the maturity date on an un-refinanceable commercial property loan, a bank can avoid taking over the property and impairing their capital by writing down the loan and the borrower can avoid a forced sale that would wipe out his equity. As credit the markets thaw, however, and banks see potential buyers for foreclosed properties, some of those forced-sales are going to happen, allowing cash-rich value investors to buy good properties at deep discounts. But remember, to be a cash-rich value investor you have to have cash, so be patient.
My Favorite Whine—Things That are Not a Thing
Thinking is hard work, which may be why people go to such great lengths to avoid it. Jargon is one of the short-cuts that people use to suppress thinking and deflect questions about issues they think are already decided. At best, jargon can save a little time by compressing a paragraph into a single word. At worst, it channels all subsequent mental activity into well-worn grooves, leading to a kind of group-think that is more like a religious mantra than analysis. Unfortunately, when the world gets complicated, jargon-users rarely know how to rewind the tape and question their basic assumptions. That’s why I try so hard not to use jargon in the things I write.
I think of jargon that doesn’t make sense as things that are not a thing. Here are some of the most egregious terms on my “things that are not a thing” list:
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Modern Referring to your own thinking as “Modern” takes a special kind of hubris because it basically says that all of the ideas that have come before were just the on-ramp to the correct way of thinking—the way you do it now. That is just as true for Modern Portfolio Theory as it is for Modern Macroeconomics and Modern Monetary Theory, referring, respectively, to the illusions that you can control risk, that you can control the economy, and that you can print all the money you want without creating inflation. None of them are true.
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Optimal Portfolio. The illusion that you can measure the risk of owning an asset by how much its price flops around (calculating the standard deviation of its trailing returns and their correlation to the returns on other assets) is a load of bunk. IMHO, risk is the chance that the thing you bought doesn’t generate the cash flow you thought it would when you bought it, which is a different beast altogether.
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Risk-On, Risk-Off. These are terms people made up to explain away the times when the correlation coefficients they use to build so-called optimal portfolios don’t stay put. Correlation coefficients and covariances are not facts of nature; they are accidents of history--more like your brother-in-law who is never there when you need him.
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Alpha, Beta. These are terms that only have meaning if you have already bought into the jargon I have already talked about. I don’t, which is why I never use those terms.
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r*, or R-Star.This is a term that macroeconomists and Federal Reserve officials use to refer to some magical interest rate that would be “just right,” like the baby bear’s bowl of oatmeal in Goldilocks, leading to both full employment (general equilibrium) and no inflation at the same time. Fact is, r* only has meaning if you have already accepted Modern Macroeconomics (see thing #1 above), an economic model built on the idea that there is only one person in the economy, who is really smart, and that you can ignore the assets on the balance sheet that, in the real world, add up to more than 15x annual GDP.
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Space, as in “This is the fastest growing company in its space.” Call me old fashioned but to me, space is either a place where you can park your car, as in “parking space” or a frontier where no man has ever gone before, like Star Trek. It is not a code word for an industry or an economic sector. The first time I ever heard “space” used this way was in 2001, at the height of the dotcom bubble, when an investment banker brought a high school kid to my office who wanted $10 million so he could use the internet to build an online shopping mall that would “redefine the retail space.” It was a short meeting.
These will do for a start; I will be adding more to my list in future posts.
Dr. John
The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.