Geopolitical Risks Percolate, Economy to Glide Lower in Q2

Marc Zabicki:

Welcome, ladies and gentlemen to the latest edition of the Market Signals podcast. My name is Mark Zabicki, Chief Investment Officer of LPL Financial. I'm happy to be joined today by Jeffrey Roach the Chief Economist of LPL Financial. We've got quite a bit to cover today, standing in for Mr. Jeffrey Buchbinder, who does an outstanding job with this podcast, but I'm hoping Jeff Roach can carry me through much of this. So there's quite a bit to talk about, a lot of activity in the market, you know, a lot of activity geopolitically certainly over the weekend. So before we get into it, let's talk about disclosures for a second. Okay. And then the agenda for what we're going to cover is the market recap, as we always do at the Market Signals podcast, knees buckling just a bit in terms of what's going on in the equity market.

Marc Zabicki:

As we sit here recording in the afternoon of April 15, we are seeing more knees buckling in the equity market. So the concern over the geopolitics is beginning to kind of resonate again as it did late last week. Geopolitical risk is something that we talk about a lot as a Strategic and Tactical Asset Allocation Committee. It is real and it is heightened as far as we're concerned. And one of the reasons why it's heightened or a result of a heightening risk geopolitically is that oil prices are indeed up. We'll talk a little bit about that. Most of this time will be dedicated to Jeffrey Roach's comments on global growth and the moving parts therein. And he'll also talk about some risks to the outlook. Jeffrey, do I have that correct?

Jeff Roach:

Yeah, that sounds good. We got a full plate on Tax Day here as we're recording.

Marc Zabicki:

<Laugh>. Okay. So just to talk about the activity in capital markets over the last week it was somewhat tumultuous, ended with a downdraft in Friday's market the S&P 500 down about, you know, 1.5% or so for the period. NASDAQ Composite was a little bit more resolute, the Dow Jones Industrial Average, however, was off quite a bit for the week. That didn't really resonate across global capital markets as we were generally higher across Europe, although U.K.'s FTSE 100 Index did witness a little bit of a downdraft. And I know Jeff, the Japanese equity market is of particular interest to you. The Nikkei was off about 0.7% last week. So, tell the audience, you know, why Japan you think is, why do you think Japan is so important?

Jeff Roach:

Yeah, I think you know, it's a major currency for carry trades. It's a little more technical than, you know, what we typically talk about in this podcast, but, you know, part of the reason why I think it's worth highlighting Japan is we've been interested in that and favorably disposed, you know, for the last year or so, and interesting dynamics in the very, very near term that things seem to be changing or at least poised to change. We'll talk more about it in a few slides, but certainly worth highlighting here in this podcast.

Marc Zabicki:

Yeah. And looking across equity sectors a lot of red that showed up. You know, although technology was relatively healthy other major equity sectors not so much. Moving to fixed income, which yields were on the rise a little bit last week, which, what put some pressure on the Barclays Aggregate Bond Index. Most of the rest of the high yield market, you know globally was lower. Although the Euro Ag was indeed higher by about 40 basis points. Across commodities, the lift in commodities recently certainly speaks to some of the geopolitical concern that we've seen. And we'll take a little bit of a longer look at oil prices, but energy a little bit off last week, but generally good over the last month. And I know, Jeffrey, that you're paying some close attention to precious metals.

Jeff Roach:

Yeah, precious metals is noteworthy right now. A couple reasons. One is, you know, a lot of global central banks are buying up gold specifically, but also, you know, with last week's surprise release on the CPI, the Consumer Price Index, and what it means for policy, both here as well as, you know, a broad, you know, inflation is sticking around longer than expected, putting the Fed a little bit into the corner here, and one of the market responses is, you know, a pretty decent sizable rally in gold and other precious metals.

Marc Zabicki:

Yep. So, we're expecting some continued strength in the near term in the commodity index, especially as in broader commodities, especially as this geopolitical thing continues to play out. We've talked about in our asset allocation committee since the beginning of the year, that this is not going to be an easy year from a geopolitical risk and a political risk perspective. And while the market's kind of been on a run I think it belied a little bit of the pending risk that was out there. And some of what we've seen over the last, you know, week or so certainly is perhaps a little bit more reminiscent of the global equity risk that we thought we would see at the beginning, you know, of the year. So something to keep continue to keep a close eye on.

Marc Zabicki:

If we look at the impact across the top pane of this chart, which is the S&P 500 index, and then the lower pane, which is the 10-year Treasury yield, we can see some pressure in both markets. Obviously, the recent weakness in equities has kind of taken us below trend in terms of what's been established in the U.S. equity market since about the fall of, you know, October of last year. The technical weakness that we see in U.S. equities is not a surprise to us, but we're actually finally getting what we've been expecting here over the near term. So technically some weakness, something to keep an eye on would perhaps lead us to believe that we are now going to see, or we're beginning to see that correction that we have been talking about. In the Treasury yield

Marc Zabicki:

we are seeing a lift in Treasury yield. Certainly, the trend has been slightly higher since December. I don't know that the trend goes higher to 5% or above 5%, because I think there's too much risk geopolitically for that to happen at the end of the day. The 10-year Treasury yield or Treasury markets in general are safe haven assets, and they will remain safe haven assets. Just as you mentioned, Dr. Roach, precious metals are safe haven assets, the dollar is a safe haven asset. So but some pressure in the Treasury market, likely due to a little bit hotter inflation read than we thought we were going to get. And I know you're going to touch on that. Moving before I turn it to you Dr. Roach, to crude, again, this is interesting to us and certainly beneficial to our energy call. We are overweight, you know, energy. The sector and the U.S. equity market has been you know, keenly driven by energy prices, oil prices in general since December, something that we continue to see. So, the geopolitical risk is only additive to what we think is a fundamentally strong energy position as well as a technically strong energy position. Any comments on oil, Dr. Roach as we look at this chart?

Jeff Roach:

Well, you know, one of the things that's still a little bit of a wild card, we look at this, the economics in China, you know, the demand out of China is that wild card as I just mentioned, you know, potentially pushing prices higher if there's enough traction coming out of China, and the Asia Pacific region. Right now, at this point, you could probably say China's economy is sputtering. It's not, you know, solid growth. And you could say, you know, perhaps there's a little bit of upside if there's a little bit of regaining from the economic side of things out of China. That's something definitely worth watching going forward.

Marc Zabicki:

And speaking of that, turning it firmly to you, Dr. Roach. I mean, you know a key question I have, and I'm sure a lot of folks in the audience have is that the economy's been better than expected probably. And, but people constantly are talking about, you know, some weakness in the economy, and we are going to get GDP growth this year that's less than we saw in 2023. So, talk to us a little bit about some of the moving parts globally for starters, and then we'll get down into some granularity here in the U.S.

Jeff Roach:

Yeah, that's right. So we'll start on the global picture, global growth forecast, and then talk about a little bit of the risks to the outlook. And you're exactly right, Marc, you think about the amount of cash that businesses have on hand, the amount of cash that households have on hand, particularly because of millions of folks that were able to move out of higher cost of living areas to lower cost of living areas, able to free up a little bit more cash, that hybrid work environment, that structural shift in the labor market has certainly showed up in consumer spending numbers. But I think what's really nice in this graph, and this is why I wanted to highlight it for our audience, is that, you know, there's a lot of moving parts in an economy, and this index helps us benchmark it when we compare economies to economies.

Jeff Roach:

So you think about, first of all, think about your typical open economy and I'll explain what that means in just a second. You know, you have businesses that are buying and selling, you know, buying equipment, buying computers, you know that capital expenditures. You got households that are buying both goods, such as furniture and cars, also services such as financial services, recreational services. Then you have government activity, and then you have trade. That's the open economy, right? There's an interaction between imports and exports. So if you look at those four things, I'm just simplifying it, that's your typical metric that helps us identify, you know, where businesses are heading. Where's the consumer heading? Where's government spending heading? What does trade look like? When you take all those higher frequency data points, put it into one metric, say, where is the economy growing relative to long-term trend?

Jeff Roach:

So this picture right here, and this is why it's so powerful, basically saying zero, right at the zero line, that's that benchmark long-term trend. That's your boring plain vanilla. The economy's growing at trend. Well, given what these data points that are coming out every day, what those data points tell us about an economy, does it look like the economy is going to be going above trend or below trend? If that bar is above trend, above the zero line, that's above long-term trend. So you see Brazil and U.K. Below trend growth, well, there, Japan far right, but the U.S. and this is why it's worth highlighting, the U.S. is second one over from the right suggesting that, you know, we could still have 2% growth. You see that in the orange font there in the subtitle, you still have 2% growth for 2024, fairly solid. In fact, it's faster than what we typically see in Japan, even in some areas of Europe.

Jeff Roach:

That's very, very sluggish because we have better productivity here in the U.S. but it's below long-term trend. So everything is compared to that benchmark of long-term trend. So I think what we're seeing here, and I'll tie in a little bit of what's happening in more recent days into what this metric tells us. And that is, you know, we're probably going to slow, whether it's the third quarter or the fourth quarter this year, or whether it's the second quarter we're going to slow. In fact, a lot of market watchers are expecting that. What we are saying here at LPL Research, this is why it's important to look at this. Perhaps it's sooner than Q4, right? We're starting to see some slowdowns already, even this morning's retail sales numbers, pretty hot. So Q1 is running pretty hot, Q2, Q3 is where we see that slowdown.

Jeff Roach:

In fact, that's actually going to argue for the Fed finally able to respond as inflation cools because the economy cools. But we have to wait. And that's the frustrating moment I think for investors. And this is part of the reason why we have this a little bit of an uptick in volatility, not just geopolitical risks. That's certainly one of the reasons, but also just uncertainty about rates and where the economy's heading. But I think this is a nice you know, a lot of information in one picture. This is a great way to frame the global growth outlook.

Marc Zabicki:

Agreed. Most folks below that zero line, as you mentioned, so the fact that, you know, people hear that, you know, things are slowing should not really be a surprise, because that's effectively what this chart tells you.

Jeff Roach:

Yeah, exactly. And of course, you know, the big debate is magnitude of slowdown and timing of the slowdown. You know, so we could see very close to zero growth quarter on quarter once we hit say Q3, but for the year, we expect the economy to grow positive. Well, that's why I have 2% right there, below long-term trend, but certainly positive, particularly because we started right out of the gate so strong in January, and that's continuing through February and March as well as we get the data.

Marc Zabicki:

Okay. So yeah, and I know you and Lawrence Gillum, our chief fixed income strategists, you know, both Fed watchers and certainly the Fed drives much of what goes on in the economy. And I know you know that, so give us a read on, you know, how the balance between what the ECB may or may not do with its policy and what the Fed may or may not do with its policy and how it, you know, today may be a little bit different than it has been in the recent past.

Jeff Roach:

Yeah, it is going to be interesting this time around because there's a couple reasons. One is because we're starting to see Europe have potentially less sticky services inflation than what the U.S. is experiencing right now, even excluding housing. Because it's really hard to compare what we have, and I'll kind of nerd out here, just a moment on the data. The owner's equivalent rent component, which is an imputed value in the CPI, the Consumer Price Index, is very difficult to compare the hypothetical imputed owner's equivalent rent in Europe. So that's what I like when I like to compare numbers. I say, well, let's strip out housing. Let's look at services in general, like financial services, insurance, et cetera. And we're seeing a stickiness here in the U.S. more than in Europe. And because of that, we could have something that's never happened before.

Jeff Roach:

And that is the European Central Bank can actually cut rates potentially before the U.S. Central Bank does. The reason why we should care about that and I just explained the economics behind why it could happen, we should care about it because it impacts dollar Euro exchange rates, it'll impact trade dynamics, and certainly impact yields. Because if the Fed can't cut as quickly and typically like they normally do, they lead the way. I show this graph here, going back to the late 90s. Fed hikes, then the ECB follows. Fed goes on pause, ECB eventually pauses. Fed cuts, I'm just looking at that orange line that's the fed funds rate, ECB follows. Typically, it's follow the leader with the Fed. ECB at this point may actually lead the way, not just follow this time around.

Marc Zabicki:

Yeah. So you know, I know, and correct me if I'm wrong here, Dr. Roach, is that the manufacturing sector of the European economy, for example, is more prevalent than it is here as you noted. And we're seeing more improvements in the rate of inflation in the manufacturing side, than the services side, while the services side still feels like it's getting a tailwind from the U.S. consumer. Is that fair?

Jeff Roach:

Yeah, the U.S. consumer is the right way to look at it. I think you can boil it down to this. A lot of countries in the Eurozone had a recession. We never had the recession. So because they had a recession, particularly Germany, think about those other countries that had aggregate demand pull back, right? So the strength of the consumer in Europe has not been as strong, hence, the demand for goods and services had not been as strong. Hence, the inflation rates were able to fall sooner than we see here.

Marc Zabicki:

Yep, yep. And the many moving parts of U.S. inflation, a lot of them are really detailed in this table. I like the fact how this moves from like red to green to yellow and kind of paints a picture as to what's going on in U.S. CPI, Consumer Price Index. So, Dr. Roach, what are the key elements here in this table?

Jeff Roach:

Well, first of all, before I say anything about that, you know, the good news is for our listeners, they can hit the pause button and take a screenshot of this and be able to digest it a little bit longer than the, you know, 40 seconds that we're going to talk about it. And so the key here is you think about the pipeline of inflation. Inflation is not necessarily when, you know, when I go to the store and buy something, yes, that's the end result, but there's a whole number of steps that happen before that, right? Import prices, producer prices, supply chains. So hence when you read this chart, you look from the top down. You look at those beginning components of pipeline inflation, and then at the very bottom of the chart, as I show the Fed's preferred metric, which is from the actual personal income and spending report, we call it the deflator.

Jeff Roach:

But the PCE Deflator, PCE just stands for personal consumption expenditures, but that deflator is perhaps a little bit better of a read, right? Part of it's not going to be as impacted by this imputed value of what, even though I'm a homeowner, what would be the market rate if I had to pay a rental price for the home that I'm in? Clearly not something that impacts my actual checking account. But something that shows up in the CPI number. The bottom line here is, you know, we're seeing a little bit of challenges with international trade. You see import prices going from green to red. A little bit misleading because the green is just coming off of an extremely low number, minus 4.8% roughly year on year on import prices last summer. So we're still seeing pretty soft import price inflation, just barely above zero in March. But it's red because we're comparing to such massive declines in import prices last summer. Key takeaway here is inflation here in the U.S. is definitely sticky. We actually have a forecast that we'll be closer to 2% by the end of the year. A lot of that's driven by slowdown in demand, but I think we should not be surprised at all if we have a two handle, as we say in trading parlance, a two handle in the inflation rate by the end of the year.

Marc Zabicki:

Yeah. And that's interesting because you know lately in conversation with other industry folks, you've heard them indicate, you know, inflation is going to be stickier than many people think. You just said that it's likely not going to be as sticky as some people have said. And get closer to that, you know, 2% to 3% range within that range, that is. So, I mean, any further color on that, Jeff, as you think about CPI? Because I agree with you. I think inflation is likely going to get lower than people really are now anticipating.

Jeff Roach:

Yeah, but we have to be patient. I think the key is when is that going to happen? Well, it's going to show up probably in the third quarter, right? So, you know, consumers still have a lot of cash. They're playing catch up on the lost time that they had during the shutdowns and even the years following shutdowns. I'll actually show that in the slide in just a little bit. But when we see now that the consumer will have plenty of opportunity to say, look, we've made up for lost time the last several years, slow down and aggregate demand, at least by Q3, that's when we'll start seeing really, really strong progress being made on the inflation front.

Marc Zabicki:

That's a good point. That's a real good point. So, you've touched on services already, Dr. Roach,. walk us through this chart a little bit.

Jeff Roach:

Yeah. So remember I said it, you know, it'll take a little bit of time. Maybe it's Q3, who knows, the timing and the duration is what, you know, markets are really focusing right now. I think one of the things that I've thought very, very helpful when I've explained this dynamic to folks, you know, in the last several years or so, you think about just the breakouts of consumer spending on goods and services. That's your blue line, that's your orange line. We buy stuff and we want services. We buy services. So orange line is goods. We had that splurge in goods. Everybody, you know, wanted to redo their decorations when they had a move to the home offices. And then you had that corresponding dip when you couldn't take a cruise and you couldn't travel.

Jeff Roach:

Europe was shut down. You had to carry a, you know, vaccination card or whatever you want to say, <laugh>. That's the dip, corresponding dip in the blue line. Well, it took amazingly long for the consumer to rebound and recover and go back to pre-COVID trend on services spending, that just happened last month, which I think is very interesting and noteworthy. We still stayed way above pre-COVID trend on, you know, what we're buying from, you know the furniture, the clothes, the cars, et cetera. But look at that blue line. We're finally back to that pre-COVID trend. I think that's really going to be the linchpin for seeing aggregate demand, broadly speaking in the U.S., pull back a little bit and finally give us a little bit of respite on the stickiness of inflation.

Marc Zabicki:

Yeah, Dr. Roach, if you're like me, you're probably surprised by the longevity of this consumer pricing tailwind. Fiscal policy has a lot to do with that. Monetary policy has a lot to do with that. You touched on people moving from one region to the country of the country to another. It feels to me that the consumers is a little bit stretched here. And if we do get that slowdown in the economy, and if we do get any kind of weakness in the jobs market, that could really impact the strength of the consumer rather quickly. Is that a fair assessment?

Jeff Roach:

Well, I think you could get a little bit nervous if you see the draw down in savings and the slow, slow down the deceleration in the savings rate. So that's happened and that could be where you might become a little bit more bearish on the consumer. Clearly lower savings rate is going to show up in the amount of spending. The flip side is saying, well, the job market still is pretty decent. In fact, it's probably even more than decent, depending on which sector you're looking at. Yeah. So, job growth is there, so people that want to work can get a job most likely. Now granted, you might not be able to get the job you want. There's still a little bit of churn that we're seeing in the labor market, but the fact that the labor market has held up so well, that's giving and buying some more time for the consumer. I think in the coming months, it's going to be very interesting to see, okay, now that the consumers has gotten back to trend services spending, what's going to happen next? Are we going to see a reversal or at least kind of this going along back to trend versus playing catch up? And that's part of the reason why you've had such strong consumption numbers over the last several quarters. Consumers are just playing catch up. And that's the driver.

Marc Zabicki:

Yep. Yep. Keeping the conversation with the consumer, Dr. Roach, and I think I know where you're going with this chart, but what's the message here?

Jeff Roach:

Yeah, I think, you know, all of us can sit and listen to this podcast as consumers. But plenty of us might be saying, well, I'm also sitting here listening as a business owner. What does this tell me? What does this help me understand about the dynamics of the economy right now? And I think what's interesting is I basically just broke up. We had, again, we're, we're here recording on Tax Day, April 15, earlier this morning Eastern time, 8:30 eastern time. We got the latest retail sales numbers from March. And retail sales report breaks out where these consumers are buying or they're, you know, they're buying at a department store, they're buying online. So what I thought is interesting, and I think it tells us something a little bit about the dynamic and the sentiment of the consumer right now is saying, okay, what does the growth rate look like when you break out online?

Jeff Roach:

The government calls it, the Census Bureau, specifically, Census Bureau calls it non-store retailers. But that's your online shops versus department stores. And department store sales has been shrinking year on year consistently for months and months and months. There's your orange line and that's just basically saying, first off, consumers are looking for bargains. Secondly, think if you're a business owner thinking about what does this mean? Well, if you can pivot and change your business model from say, what you had, you know, back in 2019 to now, businesses have to be able to address this, I think a fundamental shift in behavior. This interest and this demand for online shopping and price comparing and that dynamic, but it, you know, it can show us I think the consumers looking for the bargains that tells you something about the outlook for the consumer.

Marc Zabicki:

Yeah. If COVID did one thing Dr. Roach, it got people used to ordering stuff online rather than going to the department store. Any last thoughts before we close?

Jeff Roach:

Well, I think you said it well, Marc, at the very beginning, you know, that chart, you showed you know, stocks down, yields up, you know, that relationship is holding. I think it's really helpful for our audience to just remember you know, the dynamics of being aware of the potential volatility and look to you know, look to the experts to help you navigate these waters.

Marc Zabicki:

Yeah, well said Dr. Roach. So, again, we believe that the equity market's overdue for a little bit of a correction. We may be seeing the beginnings of that, you know, right now. Geopolitical risk as a call out for us in terms of why we think that you have to be a little bit more conservative in your portfolios than you have been in recent years. And again, we're seeing that play out a little bit in equity markets. I don't think it's going to get any easier as we begin to step through the latter months of 2024. We've got elections in 64 different countries. We've got geopolitical risk, certainly a historical election here in the U.S. upcoming is going to make probably for a tumultuous time throughout the balance of 2024. I want to thank you for joining me, Dr. Roach, as always appreciate your insight. Thank the audience for joining us here at the Market Signals podcast. And we'll see you next week when Jeff Buchbinder will be back in his chair. Enjoy the week.