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The news cycles eagerly await the release of economic metrics, aiming to stir up sensational drama and captivate viewers. A large proportion of retail investors are reactive to the news, constantly worried about the next bad thing that could happen.
Recently, two major economic news items emerged. The first was GDP, which came in weaker than expected, and the second was PCE inflation, which was right around expectations. The Federal Reserve held interest rates steady during the most recent meeting and signaled that they don’t expect the need to hike anytime soon. Let us examine the two data points in greater detail.
GDP – The Consumer Is Running Out of Steam
The U.S. economy is consumer-driven. The U.S. consumer accounts for the largest part of GDP, and in Q1, the U.S. consumer's pulling back caused GDP to grow slower than expected. Historically, consumers tend to save less and borrow more when prices are high, and this is happening now.
Consumers are saving at the lowest rate since 2005-2006, which was the lowest savings rate of all time:
We see rising default rates on credit cards. Looking at earnings from a few major credit card companies, Q1 delinquencies, and charge-offs continue to rise.
For example, here are the domestic credit card numbers for Capital One (COF): Source
Net charge-offs increased from 4.04% to 5.94% year-over-year. The 30+ day performing delinquency rate increased from 3.66% to 4.48%.
For some context, here are COF's numbers from its presentation in Q1 2008: Source
History might not repeat, but it sure does rhyme. The rising charge-offs and delinquency rates are remarkably similar to 2007-2008 in amount and pace.
So we have:
GDP lower than expected primarily due to slower consumer spending.
The consumer savings rate well below average.
Consumer credit card default rates rising to recessionary levels.
When we add it up, we have a recipe for consumer spending to evaporate. Consumers who have defaulted on a credit card are running out of options – they are forced to cut back their spending because they don't have the money and they can't borrow the money.
It shouldn't be a surprise to anyone who has checked out at a grocery store that the consumer is struggling. While inflation has slowed, prices are still high. Consumers came into this inflationary spike with excess cash due to pandemic-era stimulus and low consumer credit balances. However, for many, that cash is disappearing and the debt balances are rising. Yet prices are still high.
GDP Isn't Going to Warn You of a Recession
Q1 2008 is now recognized as the first quarter of a recession; however, it was not recognized as a recession at the time. In the advance estimate in April 2008, Q1 2008 GDP was reported as having grown 0.6%. Q2 2008 GDP showed 1.9% growth in the advance and a very strong 3.3% growth in the second estimate a month later.
Q1 2008 GDP was reported as positive until it was revised in 2009 after the recession was over.
Even the initial estimates are issued a month after the quarter has ended, with final estimates coming two to three months later. All economic data is subject to revisions in the future, and these revisions can be significant. A better approach to macroeconomics is to focus on broad trends and piece together the major elements in a way that makes sense. This approach can help identify risks, such as inflation, even when initial reports indicate a lower likelihood of such risks.
PCE Inflation – How Fast Should It Decline?
Every inflation report I see people react to it with a definitive judgment. Many seem to be under the impression that once the Fed started hiking, PCE inflation should have just fallen to 2% right away. If it doesn't, then that means the Fed didn't hike enough. Already, after a single quarter of slightly higher PCE inflation, some are saying the Fed should hike rates again. I won't opine as to what the Fed will do, but I will say it would be the dumbest decision any FOMC (Federal Open Market Committee) has ever made.
Expecting inflation to evaporate overnight isn't realistic. Just like it started taking hold in 2020 and took two years to peak, it shouldn't be surprising that it takes a few years to come back down.
Let's look at history. Core PCE peaked at 4.7% in February 1989. From that point, it didn't decline below 2% until 1996.
Note that Core PCE ticked up several times during the decline. It wasn't a straight line – nothing in economics is ever a straight line. It just isn't how the world works.
Did the Federal Reserve wait until 1996 to cut rates? Not at all. It was generally cutting the effective Federal Funds Rate until 1994.
If we compare the past two years to the inflation spike in 1989, we can see that inflation is falling relatively fast. A couple years after peaking, Core PCE was still over 3.5%. In February 2022, Core PCE peaked at 5.57% (higher than 1989) and two years later is down to 2.82%
This is a much faster pace of decline than we saw in the early 1990s.
If we go back to November 1980, Core PCE peaked at 9.78% and the Volcker Fed hiked the effective Federal Funds rate to over 19%. Despite this brutally high-interest rate, inflation bottomed at 2.83% seven years later.
PCE did fall at a good clip, with April of 1981 to June of 1982 being the longest monthly streak of annual Core PCE being flat or declining in history. The current streak started in January 2023 and with March Core PCE down from 4.84% to 2.82%, the current streak of slowing Core PCE matches the longest streak in history. One more month and it will be the longest streak of flat/declining Core PCE in history.
And yet people are freaking out over inflation "heating back up"! History tells us that we should expect Core PCE to tick up, even if it is continuing a longer-term downward trend.
Economies Are Psychological
Economic activity is largely psychological. When businesses and consumers believe that business is good and their economic fortunes are favorable, they invest in hiring new employees, building infrastructure, buying inventory, and freely spending money. However, when consumers run out of credit, their spending is cut off, and businesses that believed customers wanted more products cut their plans. This belief transforms into the belief that a recession is happening, which then causes almost everyone to become more conservative with their spending habits, exacerbating the recession.
The 0.6% to 0.7% range is the increase in unemployment that is significant enough for employers and workers to start realizing that the economy isn't healthy. This can lead to a self-feeding cycle, where a small spike of about 0.6% above the cycle bottom snowballs into a huge increase in unemployment.
Your portfolio is like a bar of soap in many ways. If you mess with it too much or keep running water over it, it won’t last as long as it would others. The market news is a continuous phenomenon, akin to running water on your portfolio. This is why I adopt a method of investing that pays me through good and bad times. Let's look at my top picks, which are responsible for growing cash flows through these uncertain times.
Pick 1: NEP - Yield 12.1%
NextEra Energy Partners (NEP) acquires, owns, and manages contracted clean energy projects in the U.S. and natural gas pipeline assets. The United States continues its pursuits to de-carbonize and have clean energy sources such as wind and solar constitute a higher share of the energy mix, and this bodes well for NEP. The company pegs the decarbonization revenue opportunity at $4 trillion, with wind and solar playing a particularly dominant role in driving the energy transition.
NEP traded at growth stock valuations prior to management's revised guidance last year, slashing the growth outlook to 5-8% with a near-term expectation of 6% growth. Wall Street was unhappy to see the 12-15% growth go away, and the stock experienced a >50% price drawdown in a matter of days.
NEP presents excellent value today. Its highly profitable business generates predictable cash flows. The company recently raised its quarterly distribution to $0.8925/share, which calculates to a 12.1% annualized yield at current prices.
Pick 2: AHL Preferreds - Up To 9.4% Yields
Aspen Insurance Holdings Ltd. is a leading specialty insurer and reinsurer and is a wholly-owned subsidiary of Apollo Global Management (APO).
During FY 2023, the company reported an adjusted combined ratio of 86.4% and a net income of $485 million (after preferred dividends), indicating excellent underwriting discipline and profitability. The company maintains a fortress balance sheet, rated A3 by Moody’s, and redeemed its $300 million 4.65% senior notes in November 2023.
Aspen has three public preferreds, rated AA by leading credit agencies.
AHL-C was originally a rate-reset preferred, but given the announcement from the company in December, the security’s coupon will be locked at 9.59343% for the foreseeable future. This is terrific, as it gives us a 9.4% yield at the current cost, and is quite likely to be redeemed soon. Aspen’s dividends constitute QDI, and for those seeking high yields for longer, AHL-D and AHL-E offer +7% yields and +25% upside to par.
Conclusion
The market news cycle revolves around what is happening right now. It focuses on how stocks will react to one month of data, even though that data is subject to significant revision in the future.
In the meantime, we can continue to add high-quality income picks to our portfolio. At High Dividend Opportunities, we have focused on our fixed-income portfolio for the past several months. The primary reason is that some of the best opportunities to buy are in fixed-income.
There will be a recession eventually, and the Fed will cut, eventually. The timing of these events is uncertain. In the case of a recession, historically, it isn't known that a recession is happening until several quarters after it starts. It is best to avoid reacting to the market's short-term reactions. Stay focused on the long-term trends, and make sure you are buying up income that you believe will be sustainable through a variety of economic outcomes. This is the beauty of income investing.
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