Topic Tags: U.S Economy

Airline Stocks: Just Plane Challenged

Although travelers have happily bid farewell to pandemic-related restrictions and returned to the skies en masse, airline stocks seem to have missed the memo on bouncing back to pre-COVID levels. To that point, the Dow Jones U.S. Airlines Index has returned roughly -35% since the start of the pandemic. This cumulative performance figure is despite a surge in the index in the wake of vaccine announcements in late 2020, as well as the fact that that this summer may be the busiest travel season the U.S. has ever seen. These dynamics can be observed in this week’s chart.

The dichotomy between booming travel numbers and lackluster airline stock performance can be attributed to several challenges facing the industry. Specifically, while increased passenger volumes boost revenues for major airlines, these businesses continue to grapple with profit margin pressures stemming from soaring operational costs. For instance, higher oil prices (now $80 per barrel compared to roughly $55 before the pandemic) have proved to be a significant headwind for airlines. Additionally, ongoing issues including pilot and crew shortages, escalating wages, operational inefficiencies, and higher maintenance expenses have further constrained airline profitability in recent time. Spending on corporate travel has also been somewhat tepid over the last few years as well, which has presented problems for airlines that offer premium upgrades such as business class seating.

In conclusion, the challenges faced by airlines will likely persist into the near future, though robust passenger volumes are certainly a cause for optimism. As it relates to investor exposure to these types of stocks in general, four major airlines (American, Delta, Southwest, and United) are constituents of the S&P 500 Index, and these carriers comprise roughly 0.2% of the benchmark. In other words, adequate diversification should mitigate the impacts of the headwinds described above at the portfolio level.

The Capital Structure Shuffle

In the years following the Global Financial Crisis, issuing new debt was an easy decision for companies looking to raise capital given an environment of historically low interest rates. That said, decisions related to the composition of corporate capital structures are now less straightforward due to seismic shifts in monetary policy that have taken place in recent time. To that point, this week’s chart compares the yield-to-worst of the Bloomberg U.S. Corporate Bond Index, a proxy for the cost of debt, to the earnings yield of the S&P 500 Index. The earnings yield is calculated by dividing earnings-per-share by the price of the index and is used as a proxy to determine the costs companies face when it comes to new equity share issuance (i.e., the lower the earnings yield, the cheaper it is to sell shares and vice versa). As readers can observe in the chart above, this yield now sits below the yield-to-worst of the fixed income index.

Companies generally prefer issuing debt over equity due to the tax shield associated with this financing (i.e., interest expenses are typically tax-deductible), which still renders debt the more cost-efficient option for many companies in the current environment. Further, equity issuance is often viewed negatively by market participants due to the dilution of per-share earnings that arises as a result.  There are, of course, additional factors beyond the costs of debt and equity that CFOs must consider when making decisions related to capital structure dynamics. That said, in light of the trends outlined above, many companies may begin to view equity issuance as a more attractive option when it comes to raising capital.

A Jolt from JOLTS?

Throughout history, the state of the domestic labor market has typically served as a reliable indicator of the overall health of the U.S. economy. To that point, while the labor market has remained largely robust in the last few years, the most recent Job Openings and Labor Turnover Survey (JOLTS) from the Bureau of Labor Statistics may cause some observers to question the extent to which the employment landscape is deteriorating. Specifically, job openings in the U.S. decreased in April for the second consecutive month according to the report, falling by roughly 300,000 to just over 8 million. This figure represents the lowest level since February 2021 and equates to just over 1.2 job openings per unemployed individual (down from 1.3 in March). As can be seen in this week’s chart, April’s drop is part of a gradual decline in job openings that has been taking place for nearly two years. Interestingly, the rate at which individuals are voluntarily leaving jobs remains at a multi-year low, which could indicate a lack of confidence among labor market participants regarding the prospects of finding more attractive employment elsewhere. Not all of the April JOLTS data was negative, however, as the report stated that layoffs were unchanged on a month-over-month basis and remain low relative to historical averages.

Slowing job growth could indicate a weaker domestic economy, which makes the job of the Federal Reserve more challenging given its commitment to higher rates to combat elevated inflation. While the April JOLTS figures will likely not lead to a rate cut at next week’s FOMC meeting, further softening in the labor market could lead the central bank to weigh the employment picture more heavily when making policy decisions. Marquette will continue to monitor the impact of inflation and labor market dynamics on Fed policy and provide updates to clients accordingly.

Divesting From the Enemy

As some readers may recall, members of the Marquette Research Team presented a flash talk on deglobalization at our 2023 Investment Symposium given the proliferation of trends including onshoring and reshoring over the last several years. Another trend that supports the idea of reduced global integration is the drop in foreign direct investment (“FDI”) that has occurred in recent time. Indeed, according to The Economist and IMF, when compared to the six years leading up to the pandemic, average FDI flows dropped by nearly 20% from 2020 through 2022. A variety of factors have contributed to these dynamics, including supply chain disruptions caused by the COVID-19 outbreak, the Russian invasion of Ukraine, and trade tensions between major economic powers.

It may be of particular interest to readers to examine the extent to which capital flows between certain countries have shifted since the start of the pandemic. Perhaps unsurprisingly, the IMF notes that these shifts have been asymmetrical across geographic regions, with Asian countries bearing the brunt of the overall decline in FDI. For instance, both the U.S. and countries in Europe have materially decreased levels of FDI to China since the start of 2020. These dynamics are outlined in this week’s chart.

The Economist notes that geopolitical alignment has served as a major driver of the recent diverting of capital flows and is also a key factor in cross-border bank lending and portfolio flows. To that point, the upcoming presidential contest in the U.S., as well as other high-profile elections across the globe, may be crucial in determining the flow of capital over the coming years, as well as the extent to which deglobalization trends persist. Marquette will continue to closely monitor the impact of geopolitics on the global economic landscape and provide counsel to clients accordingly.

A Falling Tide Lowers All Boats

The resilience of the American consumer has been an unanticipated phenomenon in the four years since the outbreak of the COVID-19 virus. Massive federal stimulus in the wake of the pandemic provided the means for significant discretionary spending and has been a major contributor to overall economic strength, even as corporate earnings have wavered. Although consumer activity remains elevated relative to pre-pandemic levels, it has fallen from highs exhibited in mid-2022. At the same time, the percentage of Americans concerned with meeting certain financial obligations has ticked up, with roughly 19% of households earning less than $50,000 per year now questioning their ability to make minimum near-term debt payments, according to a recent Federal Reserve survey. This figure represents a level not seen since the onset of the pandemic. Concerns regarding debt payments among high-income households, or those with more than $100,000 in annual income, have also seen a notable increase over the last several months. These dynamics, as well as overall spending patterns for both low- and high-income households, are highlighted in this week’s chart.

It is worth exploring the extent to which consumer behaviors may have changed in light of the elevated concerns detailed above. To that point, recent corporate earnings reports speak to pressures faced by higher-income households by showing “trade down” effects, which occur when high earners increase spending on cost-efficient products. Walmart, for instance, reported an increase in sales in its latest earnings report which was largely driven by upper-income households. As consumer sentiment dropped to a six-month low in May, the retail giant also reported that shoppers continue to prioritize staples, which has helped propel growth in its grocery business. Other retailers like Five Below and Dollar Tree also show evidence of trade down effects and continue to issue warnings that consumers of all types remain under pressure from macroeconomic factors like inflation and higher interest rates.

Determining the future trajectory of consumer spending is a challenge for corporations as management teams attempt to right-size budgets and chart paths forward. While the difficulties faced by low-income consumers have been largely recognized for some time, increased trade down effects and concerns about debt payments from high-income consumers are more recent developments. In general, it appears as though consumers are becoming less tolerant of the higher prices many companies pushed through over the last several quarters. Should consumer savings and sentiment continue to fall, discretionary spending may decline as Americans across the income spectrum prioritize staples and lower-cost goods. This may prove to be a headwind for certain industries, including high-end retailers and restaurants.

The “Fix” Is In!

The strength of the U.S. economy over the last several quarters has surprised many investors, as consensus expectations from the recent past called for a recession due to rapid monetary tightening by the Federal Reserve. That said, consumer spending actually increased in 2023, and the labor market remained mostly strong as well. This divergence between the expected and realized impacts of higher interest rates has led many to look more closely at the channels through which monetary policy is connected to consumers. To that point, this week’s chart highlights one structural trend that has been shielding many U.S. households from the impact of higher interest rates.

Monthly mortgage payments and outstanding mortgage debt are often among the largest liabilities on the household balance sheets of the more than 60% of Americans who have mortgages. In the period following the Global Financial Crisis through the beginning of the most recent hiking cycle, long-term fixed-rate mortgages dominated the residential mortgage market in the U.S., making up more than 90% of originations in 13 out of the last 14 calendar years. As a result, many households have locked in relatively low long-term fixed rates on mortgage debt. As of the end of last year, the effective rate on outstanding mortgage debt in the U.S. was roughly 3.8%, while the market rate for a new 30-year fixed-rate mortgage was just below 7.0%. While this spread between new and existing mortgage rates has adversely impacted an already strained supply of housing and led to higher home prices, it has also stymied the housing channel of monetary policy transmission. Said another way, the high percentage of fixed-rate mortgages in the U.S. cushions consumers from Federal Reserve interest rate increases and, thus, limits the effectiveness of Fed policy. This is exemplified by the fact that the effective rate on outstanding domestic mortgage debt has only increased from around 3.3% to 4.0% during the current hiking cycle.

As a result of these dynamics, the U.S. household mortgage debt service ratio — which is the ratio of monthly mortgage principal and interest payments to disposable household income — has remained low, so more disposable income is available to Americans relative to individuals in other parts of the developed world. Indeed, the ability to lock in fixed rates on mortgage loans at terms of 20 or 30 years is somewhat unique to the United States in a way that is often overlooked. Canadian households, for instance, are already feeling pain from higher interest rates, evidenced by the recent increase in the nation’s mortgage debt service ratio relative to that of the U.S. To that point, Canada has shorter available mortgage terms from traditional lenders, with a maximum of five years prior to refinancing in most cases. This has left many Canadians grappling with the impact of higher rates, as most possess either fixed-rate mortgages with short-term resets or those with variable rates.

As the conversation over explanations for the surprising strength of the U.S. consumer continues, the characteristics of the domestic mortgage market are important to take into consideration. Indeed, higher interest rates have allowed many domestic households to benefit from an increased rate on assets while continuing to pay a low fixed rate on significant liabilities.

1Q 2024 Market Insights Video

This video is a recording of a live webinar held April 25 by Marquette’s research team analyzing the first quarter of 2024 across the economy and various asset classes and themes we’ll be monitoring in the coming months.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

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Mind the Gap

Any ride on the London Tube reminds riders to mind the gap: Beware the space between train car and platform as you board and depart the train. A recent trip to London brought this phrase back to me and it seemed like a perfect description of how to look at financial markets this year, with the “gap” serving as the difference between expectations and reality, most particularly in terms of interest rate cuts.

In our market preview, we identified the Fed pivot as a primary driver of financial markets this year, most especially how expectations of cuts would line up with actual Fed policy. Going into the year, the market had priced in at least five cuts, which helped fuel a furious fourth quarter rally and investor optimism for 2024. One quarter in, however, those expectations have been turned on their head. Hotter than expected inflation and jobs reports in March have created a “higher for longer” narrative with the market expecting no more than two cuts during the second half of the year. Some economists have taken an even more bearish stance, suggesting there will not be any cuts. Overall, rates rose across the curve during the quarter as current U.S. debt levels sustained the long end of the curve while the short end was relatively unmoved.

Intuitively, many investors would expect such a big change in rate expectations to weigh heavily on markets, both equities and bonds. In that sense, equity performance was surprising during the first quarter, as the upward trend from 2023 continued. Predictably, bonds suffered as rates rose, but below investment grade sectors were profitable. To be fair, though, it should be noted that equities have endured a difficult start to this month, down 4.6% through April 22 as the higher for longer narrative has gained momentum.¹

Going forward, what should we watch for from asset classes as we venture into a market environment that looks much different than what we were expecting only three months ago?

The Banks’ Real Estate Problem

First quarter earnings season is getting started, with the largest banks reporting first. In the wake of last year’s regional banking crisis and the potential new normal of higher-for-longer interest rates, all eyes are on the health of the U.S. financial system. With commercial real estate (CRE) still searching for its bottom, losses related to CRE exposures are of particular concern for the banking industry. There is $5.7 trillion in commercial real estate debt outstanding and small to mid-size banks hold a disproportionate amount of it, putting the group at higher risk. Regional lender New York Community Bancorp (NYCB) — with the fifth largest concentration of CRE loans, as shown above — garnered headlines earlier this year after reporting a sizeable fourth quarter loss and disclosing material weakness in the way it reviewed its loan portfolio, prompting a $1 billion emergency investment. While NYCB’s outsized exposure to rent-controlled multi-family property loans may limit contagion to the broader banking sector, risks remain. As consumers respond to the higher rate environment, bank funding costs increase, eating into the higher lending profits the sector has enjoyed. Combined with losses and provisions tied to the troubled real estate sector, banks may limit lending, which flows through to the consumer and economy. As the macro backdrop remains in flux and the consumer continues to adjust to a higher-for-longer environment, any bank weakness could become more of a threat and bears watching as earnings season continues.

First to Cut: The Fed or the ECB?

Based on implied probabilities derived from options markets, investors are currently forecasting an 82% chance that the European Central Bank will cut its policy rate at or before its June meeting. For the full year, market participants currently expect roughly three rate cuts by the ECB in total. By comparison, investors believe there is only a 46% chance the Federal Reserve will lower its policy rate in or before June and are now expecting fewer than two rate cuts from the U.S. central bank over the course of the full year.

Some of the primary reasons for these expectations involve both economic growth and inflation. To that point, in the fourth quarter of 2023, the U.S. economy grew 5.9% on a year-over-year basis. This is in stark contrast to the euro area, which produced 0.0% year-over-year growth for that same period. Estimates for first quarter GDP growth tell a similar story in terms of divergence between the two regions, as the U.S. economy continues to perform well due to a strong labor market and a resilient domestic consumer. On the inflation front, both regions have seen price levels fall from peaks seen in 2022, though European inflation has proved less sticky than that of the U.S. Specifically, the March reading for domestic CPI was 3.5%, which came in above both consensus expectations and the 2.4% figure for the euro area. In short, as it relates to monetary policy expectations, lower levels of economic growth call for more supportive monetary policy, and lower levels of inflation allow for such policy. Should current forecasts related to the trajectory of interest rates come to fruition, the U.S. dollar is likely to benefit relative to the euro, which may create a short-term headwind for non-U.S. equity returns. However, more accommodative monetary policy by the ECB may also serve as a medium-term tailwind for international stocks should the move result in stronger economic growth for the European continent.