Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett reflects on a calmer week in markets while Tom Mansley outlines why he believes the US consumer remains resilient in the face of recession and the why the underlying supply-demand mismatch is supportive for the US housing market.

05 April 2023

David Dowsett, Global Head of Investments

Last week was calmer after the tumultuous events of the previous couple of weeks. The calmness was driven by several key factors. First of all, on the banking side there was no material new news, and incrementally positive news in that borrowing from the Federal Reserve (Fed) discount window was lower, with USD 80 billion borrowed last week compared to USD 110 billion the previous week. In Europe, it was reassuring for European banks that the European Central Bank (ECB) authorised the UniCredit buyback. Most importantly, in a banking crisis, every day without any further pressure on deposits is positive and we had five such days last week. The S&P 500 Index banks subsector was up 4.5% and the KBW Bank Index was up 4.6%, representing a material bounce in share prices. The sector is not necessarily out of the woods yet and we need to remain alert, but we saw positive progress over the course of last week.

We saw other important data points on the price side. Globally, the numbers are showing falling inflation, perhaps not at a fast enough rate to satisfy central banks, but nonetheless we saw some encouraging data. On Friday, core PCE in the US came in at 0.3 month-on-month, compared to expectations of 0.4. The University of Michigan one year inflation expectations were also a little lower. The euro area CPI numbers came in lower than expected, although not at a pace where the ECB can stop raising rates. Spanish CPI was an interesting data point as the year-on-year number halved down to 3% at a headline level which shows some of the baseline effects as we are a year on from the invasion of Ukraine and the accompanying spike in energy prices

Two-year government bond yields were approximately 30 basis points higher on the week as a result of all this data It also meant that risk markets as a whole did relatively well. Therefore, although March was a tricky month, the first quarter has been encouraging. We have seen good performance almost across the board in the risk space during Q1, building on the recovery from last year.

Although March was a risk averse month and there was uncertainty, the dollar was materially weaker which does not normally happen in an environment like that where usually we would see a flight to quality to the dollar. This builds on the story we have been talking about over the course of the year.

This week, the economic focus will most likely move from prices to growth, as the US ISM data and activity data in Europe is released throughout the week. Most importantly, the US payrolls data will be released on Friday. The combination of the release on Good Friday and the liquidity thin market could bring about some volatility.

In the last 12 quarters, US GDP in nominal terms has risen 36%, so the economy has grown by more than a third nominally, which is an immense move. This means at the moment pricing power and profit margins for companies are relatively strong and may persist longer than expected and those with more bearish outlooks will not be vindicated. In terms of equities, it is important to separate where the headline S&P 500 Index is trading from where other markets are trading in terms of valuations. Outside of US equities, or even in the tech space within US equities, there is a lot of bottom-up value, in my view. I think there is a disconnect as the price of companies such as Microsoft and Apple, which dominate where the S&P trades, might not provide a good clue to underlying value in a lot of other more interesting markets.

Tom Mansley, Mortgage-backed securities (MBS)

As interest rates continue to rise and central banks continue to tighten, we frequently see headlines referring to ‘the surprising resilience of credit’. We do not believe it is surprising given the wider context, which we will outline in greater detail below.

A resilient US consumer in the face of recession

We carefully monitor data such as the debt service ratio and the debt-to-income ratio for the US consumer. The latter rose in the early 2000s, with many consumers taking on debt, but debt levels have reduced significantly over the past decade and a half. As a result, consumers have been reducing their balance sheet back to levels seen in 2000. What is the significance of this? It means that if the US goes into recession, the consumer will do so with a very strong personal balance sheet and not a lot of debt. Because interest rates were low for so long, many consumers took the opportunity to refinance and lock in debt at low levels of interest. It is important to remember that in the US, most mortgages are fixed rate for the lifetime of the mortgage. This means that when the Federal Reserve (Fed) raises rates, it does not hurt the consumer. This is very different to what is happening in Europe or anywhere where there is floating rate debt. There, central banks are in a very difficult position as they want to raise rates to stop inflation but this could cause a consumer credit problem. The US household debt service ratio, which represents the proportion of income used to pay debt, is currently sitting near record low rates. This makes sense because anyone who reduced their overall debt level and locked in very low rates on it is in a good position.

Another reason why we believe the US consumer is so resilient is the amount of excess savings. After Covid, the government issued trillions of dollars in stimulus, while consumers simultaneously reduced their expenditure. The Fed conducted a study, dated to the end of Q2 2022, which found that there was USD 1.7 trillion of excess savings in consumers’ accounts compared to before Covid. This creates a strong buffer to navigate a recession, and also demonstrates both why there is a need for significant tightening and why there is a lot of remaining resilience in the face of tightening.

US unemployment today is extremely low at 3.6%. In and of itself, this is inflationary, but the fact that almost everyone in the US has a job reinforces the strength of the consumer.

Greater demand than supply in US housing market

We are currently seeing a record low number of empty homes in the US. Looking at US existing home sales supply, typically five months of supply is normal but we are currently sitting at three. Prior to 2009, there were more houses coming online each year than there were households being formed. Since then, however, we have seen more households being formed than new homes being built, leading to the current situation of more demand than supply. In this situation, prices inevitably go up.

In the last 10 years, the average age at which men and women in the US get married and have their first child has risen sharply. In 2005/06, millennials started to have a greater influence on society and they stopped buying homes and started renting. In 2016, they started to buy again, but this shift led to 10 years of pent-up demand; that is why there is a lot of demand for housing today. Covid accelerated this trend but it was already in motion a few years before.

What does this mean for the US housing market going forward?

Rising interest rates are affecting the affordability of housing, but we think the underlying supply-demand mismatch provides a lot of support for the housing market. We believe it is a short-term versus long-term issue. Short term, affordability is likely to win and prices will reduce somewhat. Crucially, however, prices would have to decrease significantly even to get to where they were two years ago. We are therefore not concerned about prices going down. Over the medium term, we believe that the supply-demand imbalance will lend stability to house prices and eventually they will return to a normal relationship with inflation.