Before children’s cartoons turned philosophical, opting to promote role-modelling and self-actualisation, they were mostly about slapstick comedy and serious self, or otherwise-inflicted, injury. Back in those dark days of exposing the souls of the innocent to wanton violence, one of the most notorious villains was Wiley E. Coyote. Aptly named, the coyote was engaged in the perpetual pursuit of a Roadrunner -a bird that can go up to 20 miles (43 kilometres) per hour - yes, that’s a real thing. The chase would usually end with roadrunner running quickly above some sort of abysmal chasm and the coyote would follow. Whereas the instinct-driven bird would safely cross the void, the over-thinking and scheming Coyote would initiate the run, only to realise, always mid-way through the nothingness, that it’s running on thin air. “Back to reality, oops there goes gravity” as the great bard would say. Wiley E. Coyote would pause to look down and inevitably crash at the bottom of the canyon, usually strapped to some sort of explosive device going off and possibly an anvil landing on his head all at the same time.
In the world of economics, Wiley E. Coyote has been often used as a graphic example of gravity-defying investor behaviour that doesn’t last, what Alan Greenspan used to call “irrational exuberance”. Investors, it has been noted, can ignore fundamentals for so long, until gravity takes hold and they crash-land into reality. Interestingly, that sort of behaviour has always been associated with the Coyote and never with the Roadrunner, despite the many real-life examples of many who took serious gravity-defying bets and made it across safely. Investors are nothing, if not consumers of investments. Expecting consumers to behave more rationally than investors is, probably, folly.
This brings us to the recent market rout. The last two weeks saw some surprising data. After two months of dismal retail sales in the US, American consumers unexpectedly returned with a vengeance in January, as retail sales soared by 3% in January. The number might have been slightly unappreciated upon its announcement last week. Excluding post-lockdown numbers and October 2001 (after September 11), it was the singular best number in thirty years!
Then, last Friday, three more numbers were announced. Consumer expenditure, consumer income and, more importantly, core consumer expenditure deflator, which rose 4.7%, while last month's number was revised up. The Chicago Fed’s national activity index also corroborated that January was a good month for the economy. While less advertised than headline numbers, core consumer expenditure is the Fed’s preferred gauge of inflation. And it’s accelerating, instead of decelerating.
The announcement sent stocks down and was the final blow in wiping out all the gains for bond markets since the beginning of the year. Investors began adapting their peak interest rates to 5.5%, up from 5.25%. Considering that the Fed has been leading those forecasts higher and higher (which means the market is biased towards lower rates), we should now assume that even a 6% peak interest rate might not be out of the question, even though we think the Fed will pause at some point.
In our latest Quarterly we stated very clearly that we expect increased macroeconomic volatility in 2023, which means we also expect numbers to vary widely from forecasts. So we are not surprised by the numbers themselves. But we are surprised by the resilience of consumers.
The larger question is: Why is the US economy accelerating instead of decelerating?
The numbers represent unexpected consumer resilience in the US, at a point when everything suggested that consumption had slowed. Retail sales in November and December were dismal. Credit card delinquencies are on the rise. Consumers have dipped into their savings to keep consuming and paying 35% on their credit cards. The housing market is at Global Financial Crisis levels, and so are some key manufacturing indicators.
At the beginning of the year, most analysts believed that a sharp slowdown, if not a recession, was a given. Certainly, one of the biggest consumption numbers was not on the cards. So why are American consumers so resilient?
One possible answer may come from the structure of the US housing market. 90% of all US mortgages are fixed. Around 70% are long-term, 30-year mortgages. Following the GFC, Americans have generally stayed away from Adjustable Rate Mortgages. This means that for most consumers, the Fed’s sharp rate hikes would not affect their mortgage payments. Additionally, if someone had a mortgage of $300,000 anchored around 3% and capital of $300,000, then, following some simple financial advice, they could invest that capital at a 10y bond yielding nearly 4% and, in essence, living in their house for free for the next 10 years. This means that the Fed’s monetary transmission mechanism is very slow to react to rate changes. Consumers then could keep spending. In other words, the Fed might not have a ‘sticky inflation’ problem, but a ‘sticky growth’ problem.
In Germany and France, most mortgages are long-term and fixed rate, so we should not be too surprised if consumption patterns are similar. Already we are seeing an improvement of European consumer sentiment across the board. Conversely, in the UK 38% of mortgages are fixed at 5 years, and 42% fixed at 2 years. This means that at any given year, a lot of mortgages will need to be refinanced, at roughly 5% per annum higher than the previous years – which would be very telling about UK consumption and the relative underperformance of the UK economy.
Another possible answer is that monetary conditions just may not be tight enough. Yes, the central bank performed the sharpest rate hike in forty years. But consumers were deleveraged, and residual liquidity was ample. Rates came up, but virtually from zero. We can’t directly compare a 5% rate hike starting from zero, with a 3% rate hike starting from 5%. Some of the more hawkish members of the Fed have repeated the assertion that monetary conditions are not tight, and the question now is whether the more moderate members would look at the data and adopt that.
The third answer is plain old irrational exuberance. Contrary to economist models and theories, capitalist consumption was never meant to be rational. Else, what is the point of advertising? Why would supermarkets place chocolates -instead of random items- always near the till, as people wait patiently in a queue? Consumption is impulse. Consumers who remained disciplined for two months just ‘fell off the proverbial ‘wagon’, convincing themselves that the worst is over. As long as people have a home, they can spend.
As always, we suspect the answer is a mix of all three: a high level of long-term fixed-rate mortgages, residual liquidity and some irrational exuberance. But, true to our prediction at the beginning of the year we expect augmented macroeconomic volatility to persist. This means that numbers will remain unpredictable. This should at the very least force central banks to rethink their data dependency. Numbers jumping up and down would mean very unpredictable monetary policy, with significant implications for business decisions.
As for consumers? It’s generally advisable to acknowledge economic fundamentals when making discretionary capital outlay decisions. But sometimes, it pays to be the Roadrunner and just not look down.