Both the money supply and bond yield spreads point to a likely economic downturn late this year and into 2024, our analysis of economic figures at the end of July shows.
Economic & Financial Outlook
By most measures the U.S. economy continued to grow throughout July. The Atlanta Fed’s estimate for real growth in the third quarter is a 3½ percent annual rate. Stock prices continue to move higher as investors are confident all is well.
The problem is that all is not well. The Fed has reduced the money supply by 14 percent over the past year. Remember, the prior surge in money was so great that the average growth for the past two years remains in double digits.
With this large surge and decline in money, the economy and fixed-income markets have responded as expected. Interest rates are up sharply, and sensitive areas of the economy are failing.
From the peak in the spring of 2022, housing starts and permits are down 20 percent; existing-home sales are down 30 percent. Business has not been good. With half the companies reporting, second quarter S&P company revenues are unchanged from a year ago, and profits are down 7 percent.
What we have seen so far is only the initial response to the Fed’s tightening. The chart below shows the collapse in earnings during the government lockdown, followed by the catch-up surge in earnings in 2021. Last year’s decline was a move back to normal.
With half the companies reporting, estimated second quarter S&P 500 earnings are $160 a share, close to their long-term trend. Earnings forecasts continue to show a rising trend going into next year.
The Fed’s plan to continue monetary restraint will produce a 19 percent yearly decline in money by September. With normal lags, the main impact of removing this much money will hit the economy from the fourth quarter of this year and into the first two quarters of 2024. Expect the downturn in business to take its toll on future earnings.
Monetary Indicators and the Economy
The chart below shows the money supply measured as changes in the Fed’s holdings of securities and shifts in banks’ deposits at the Fed. As of July 26, money was down 14 percent from a year ago but still up an average of 10 percent a year from two years ago.
The dramatic money supply surge from mid-2021 to mid-2022 was followed by the sharp decline this past year, making it difficult for businesses and investors to assess the impact on the economy.
Interest rates have responded to the erratic shift in money in a normal manner. The leveling off and subsequent decline in the money supply was accompanied by the sharp increase in interest rates.
By the end of 2022 yield curves turned inverted and conventional measures turned sharply lower (see charts below).
While the behavior in fixed-income markets has been normal, the behavior of the stock market remains abnormal. When the Fed sells securities, the public pays for them by sending checks to the Fed. This shift in checking account deposits from the public to the Fed reduces the amount of money available, which usually provides upward pressure on interest rates and downward pressure on stocks.
This year, amid a steep decline in the money supply, stock prices are up sharply. The increase in stock prices in this restrictive environment is highly abnormal.
The abnormal up and down in money creation may help explain the stock market’s performance. Also, stock investors are assuming the economy will not be significantly impacted by monetary restraint.
The Fed’s ongoing restraint is likely to continue at least through September. By then, the money supply will be down 18 percent annually, and 9 percent for the two-year average growth. Beyond September, the two-year growth drops sharply and the odds of a very serious downturn increase substantially.
Sensitive Indicators
Sensitive indicators are mixed. Since the spring of 2022, housing starts and permits are down 20 percent and existing home sales are down 30 percent. Raw industrial commodity prices are down 16 percent from their peak in the spring of 2022.
In contrast, the 28 percent rise in stock prices since October 2022 has brought the S&P500 back to its monthly peak. Total new orders for durable goods are down from a year ago, orders for durable goods are up, but durable goods less transportation and defense are down. The ISM July survey shows manufacturing new orders are down but service company orders are up.
Coincident indicators also are mixed. Employment data show the economy slowing, yet job growth continues. The May ISM surveys hint at some weakness in both manufacturing and service companies. Even so, most data show the economy continues to grow.
Inflation Indicators:
Interest Rates
The latest jump in oil prices will make it difficult for inflation rates to decline quickly. As a result, monetary policy is likely to become more restrictive in the months ahead. Both the money supply and yield spreads point to a likely economic downturn late this year and into 2024.
As a result, we are probably close the peak in short-term interest rates. Our forecast assumes the Fed will keep the fed funds rate near its current level through 2023.
Although timing the Fed’s interest rate decisions is speculative, the weakness in the economy by year-end should be sufficient for short-term interest rates to begin to decline by the beginning of 2024.
Stock Prices
The S&P500 is back in the vicinity of its all-time high reached at the beginning of 2022, currently up 28 percent from its October 2022 low. The surge in first quarter earnings shown in the chart below has earnings 22 percent above their longer-term trend.
Our estimate of the fundamental value of the S&P500 uses the longer-term earnings trend as our input for profits. It then uses the level of longer-term interest rates to discount earnings based on those interest rates.
With Moody’s AAA bond at 4.7 percent, the fundamental third-quarter value of the S&P500 is 3,900. With the S&P500 near 4,600, stocks are 18 percent overvalued.
Although we don’t use current earnings in our model, the upcoming trend has the potential to impact the outlook for stocks. With our forecast for a downturn in the economy and profits, we expect stocks will be under downward pressure. As such, we continue to be cautious about the outlook for stocks.
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