We don’t have any empirical evidence, but our intuition is that a survey of economists guessing forward from 2020 would have predicted financial market doom with an overnight interest rate of 5.25%-5.5% in the middle of 2024. The economy and financial markets held up to these higher interest rates and have, in fact, performed amazingly well. The bond markets have not collapsed, the US dollar is holding quite firmly against other major currencies, the stock market is near all-time highs and unemployment is less than 4%. We can all speculate as to how and why, but the reality is that things in general are WILDLY better than one would expect considering the circumstances. The recession that many economists have been predicting hasn’t materialized and the big question is, of course, will things continue to hold strong?

At least some of the performance of financial markets can be attributed to expectations that the Federal Reserve will be bringing interest rates back down – asset prices in general will be higher with lower interest rates, all other things being equal. The Fed politically has to have a handle on inflation to justify lowering interest rates. Part of getting a handle on inflation is the Fed succeeding in demand destruction. This is a deflationary force combatting the inflation that the Fed created. So, strangely, we are back to the dichotomy of a few years back where bad economic information is good for the price of bonds and stocks. Bad information has been coming out and this week is no exception. Here are some recent reports:

• The manufacturing ISM (Institute for Supply Management) slipped again in May and was below expectations.
• OPEC has recently agreed to extend its production cuts of crude oil until 2025 as outlook for demand is soft.
• A restaurant collapse is showing a weaker middle-class consumer. Applebee’s is closing 35 more stores, Boston Market and Red Lobster are contemplating filing for bankruptcy protection as sales struggle. Even McDonalds is feeling the heat and they are about to launch a $5 meal-deal for a promotional month to attempt to juice sales.
• The widely tracked University of Michigan survey of consumers released last week showed consumer sentiment leaking to the lowest levels in six months.
• The Chicago PMI numbers for May were a train wreck. This is the fifth month of contraction for the index – well below expectations. This is a widely watched economic indicator and is one data point of an economy starting to struggle under tight monetary conditions from the Fed.
• Government spending is the one spot where we can see strong growth. The Federal government has already rung up a $1.4 trillion deficit putting it on pace for a $2 trillion deficit. This is a 7% budget deficit when the economy is supposedly doing well. What happens if the economy clearly goes into a recession?

The government filling some of the gap with deficit spending is the part that worries us the most. The economy has held together well under higher interest rates, but we are stacking a public debt load together that will have to be dealt with at some time. Here is a visual of the ever-increasing debt load…

 Again – not only is the debt load going higher, but the interest rate is staying higher for longer than anticipated. So, the interest owed on all this debt is now at an annual run rate of about $1.1 trillion…

Fed Funds Futures are trading with a more than 50% probability that the Fed will lower interest rates by the September meeting. We don’t think a .25% move really means anything to the economy – we are just hoping the Fed doesn’t really break something and get forced into drastic interest rate changes. With the geopolitical risks out there, we may be asking a lot…

Not to sound like a broken record, but the economy and financial markets are holding together well considering the headwinds out there. A recession DOES NOT appear to be in the works – but some indicators look a little weak in the short term. As leveraged as the system is that could start to domino. In the long run we are nervous about debt loads, but there does not appear to be an imminent reckoning. Stay tuned…

Regards and good investing,

Greyson Geiler