Dear Clients & Friends,
This week, we have an economic risk update courtesy of our good friends Brad McMillan and Sam Millette. Before we begin, let’s take a brief look at some important economic factors that were released last week.
On Wednesday, June’s existing home sales report was released. Sales increased by 20.7% during the month, after falling by 9.7% in May. This result was slightly below the forecasted estimate of 21.4%, but still represents the best single month for existing home sales growth on record. Sales of existing homes were supported by declining mortgage rates, with the average 30-year national mortgage rate falling from 3.51% at the beginning of June to 3.27% at the end. Still, despite the strong rebound for this indicator in June, existing home sales are down more than 11% on a year-over-year basis. Thus, very real work needs to be done in order to get this portion of the housing market back to pre-pandemic levels.
Thursday saw the release of the weekly initial jobless claims report for the week ending July 18. Unexpectedly, initial unemployment claims rose during the week. This outcome, with claims up to 1.416 million from 1.307 million the week before, was worse than the forecasted 1.3 million initial claims. The July 18th report marks the first increase in initial unemployment claims since the index peaked at more than 6.8 million claims in late March. This disappointing result reflects a slowdown in the pace of economic recovery, as rising coronavirus case counts led to a notable moderation in economic activity. Continuing unemployment claims were a bit more encouraging, falling from 17.304 million to 16.197 million. Still, even with this better-than-expected improvement, continuing unemployment claims remain elevated at historic levels. Continuing claims are reported on a one-week lag to initial claims. Ultimately, these indicators show that rising case counts present a very real challenge to economic recovery.
On Friday, June’s new home sales report was released. New home sales came in far better than expected, increasing by 13.8% for the month (a 3.6% increase was forecasted). This result follows an upwardly revised 19.4% increase in new home sales for the month of May. June’s performance brought the pace of new home sales to its highest level since 2007, as record low mortgage rates led to a surge in sales. New home sales represent a smaller, and often more volatile, portion of the housing market than existing home sales. Nonetheless, strong performances in May and June indicate that sectors of the housing market serve as bright spots in the initial economic rebound.
Now, let’s move into our monthly update…
June saw a strong rebound in many of the economic factors that we track in this piece, with results largely coming in better than expected during the month. These positive results as reopening efforts took hold throughout the country in May and June indicate that the initial pace of economic recovery was likely faster than originally expected. Some of the notable highlights include significantly better-than-expected improvements for service sector confidence and the June employment report. While the data releases in June were encouraging, we still have a long way to go to get back to pre-pandemic activity levels, and risks to the economic recovery remain that should be monitored.
The Service Sector
Signal: Yellow light
This measure of service sector confidence far surpassed economist estimates. It increased from 45.5 in May to 57.1 in June, against calls for a more modest increase to 50.2. This is a diffusion index, where values above 50 indicate expansion. So, this swift rebound back above 50 after hitting a 10-year low of 41.8 in April is very encouraging. The service sector accounts for the lion’s share of economic activity, so the rapid recovery in confidence we saw in June was a good sign for the ongoing economic recovery.
Reopening efforts in May and June served as a tailwind for service sector confidence during the month; however, there is some concern that rising case numbers could lead to a slowdown in reopening efforts that, in turn, could negatively affect confidence going forward. But given the significantly better-than-expected increase during the month, we have upgraded this signal to a yellow light for the time being.
Private Employment: Annual Change
Signal: Red light
June’s employment report came in far above expectations, with 4.8 million jobs added during the month against economist forecasts for roughly 3.2 million new jobs. This marks the second month in a row where job creation came in above expectations, indicating the reopening efforts led to a faster-than-expected surge in hiring and economic activity. The unemployment rate fell to 11.1 percent in June, down from 13.3 percent in May and better than economist expectations for 12.5 percent.
This strong report, following May’s better-than-expected result, indicates that the worst of the damage to the job market may be behind us. With that being said, the damage caused in March and April still leaves overall employment levels far below where we were a year ago, and we will need several more months with similar very strong job creation to get back to pre-pandemic levels. Despite the positive results over the past two months, we’ve kept this indicator at a red light for now given the fact that overall employment levels are still extremely weak on a year-over-year basis.
Private Employment: Monthly Change
Signal: Red light
These are the same numbers as in the previous chart but on a month-to-month basis, which can provide a better short-term signal. While June’s better-than-expected report was positive, the report needs to be taken in context, as we lost more than 20 million jobs in April. Additionally, the unemployment rate of 11.1 percent in June still represents the third-highest level since World War II, trailing only April’s and May’s record results. Given the massive disruption to the job market in March and April and the still historically high unemployment rate, we are leaving this indicator at a red light.
Yield Curve (10-Year Minus 3-Month Treasury Rates)
Signal: Red light
After spending the fourth quarter un-inverted, the yield curve re-inverted in January, remained inverted throughout February, and un-inverted again in March, where it has remained throughout the pandemic. This un-inversion was driven by a sharp drop in short-term rates, which in turn was caused by the Fed’s decision to cut the federal funds rate to effectively zero percent in March. The yield on the 3-month Treasury remained largely range bound in June, rising modestly from 0.14 percent at the end of May to 0.16 percent at the end of June. The 10-year yield also increased modestly during the month, up from 0.65 percent to 0.66 percent.
While an inversion is a good signal of a pending recession, it is when the gap subsequently approaches 75 bps or more that a recession is likely. We finished June with a spread of 52 bps, and the National Bureau of Economic Research (NBER) declared a recession started in February. In light of that, and with the spread remaining near the critical level, we are leaving this indicator at a red light.
Consumer Confidence: Annual Change
Signal: Red light
Consumer confidence increased by more than expected during the month. It rose from a downwardly revised 85.9 in May to 98.1 in June, against an anticipated increase to 91.5. This result, which marked the best single-month increase for the index since 2011, helped calm concerns about rising COVID-19 case counts negatively affecting consumer confidence. Encouragingly, both major measures of consumer sentiment increased in both May and June, indicating that April’s terrible results are likely the low-water mark for these surveys.
Despite the continued improvement in June, on a year-over-year basis, consumer confidence is still down a concerning 21 percent. Confidence declines of 20 percent or more over the past year are typically signals of a recession, which is consistent with the NBER declaration. Given the continued weakness on a year-over-year level, we have left this indicator as a red light for now, with an upgrade to yellow possible if July’s data shows continued improvements on a monthly and annual basis.
Conclusion: Economy in recession, but signs of faster-than-expected recovery
June’s economic data releases largely came in better than expected and painted a picture of a swiftly improving economy. Despite the better-than-expected results, there are still potential risks that must be monitored. The rise in coronavirus cases in June led some states to slow or, in certain cases, even rollback reopening efforts. These measures will likely help slow further outbreaks; however, they risk slowing the economic recovery. There are also other risks to watch out for, including rising trade tensions between the U.S. and China, as well as growing social unrest here at home.
Ultimately, while June showed the economy continuing on the path of recovery after setting an apparent bottom in April, there is still a long way to go to get back to pre-pandemic levels, and setbacks are likely as we go. Given the continued low levels of economic activity and the damage that was caused in April and March, we are leaving the overall risk level at a red light for the economy as a whole for July.
The most difficult thing we have to consider is whether or not participants in the market’s recovery have properly considered the innumerable risks that lay ahead. As we mentioned last week, either the economy will catch up to the market (rendering its recovery warranted), or the market will catch up (or better yet, catch down) to the economy. Aggressive and speculative investors can benefit from continuing to ride this momentum. However, moderate and conservative investors could face a very damaging reality if the market falls. More than ever, diversification is our best risk mitigation. With the exception of aggressive and speculative portfolios, we continue to prioritize risk over reward for the majority of our clientele.
We hope that you are finding our risk and coronavirus updates helpful. We wish everyone a wonderful weekend.
-Your family in the home office