RQA Economic Insights: January 2024 — Richmond Quantitative Advisors

RQA Indicator Spotlight: consumer Sentiment Update

In our latest update, we revisit consumer sentiment data to examine the changes since our previous review, particularly in light of the favorable performance of risk-oriented assets broadly throughout the year.

To recap briefly, we rely on the U.S. Michigan Consumer Sentiment Index to gauge consumer sentiment. The index is compiled based on survey results, which assess consumers in three key areas: 1) their outlook on personal financial prospects; 2) their view on the near-term economic outlook; and 3) their perspective on the long-term economic future.

Conducted monthly, this survey poses 50 core questions, each designed to capture various facets of consumer attitudes and expectations.

*Source: University of Michigan: Consumer Sentiment, Analysis by RQA*

Going back over 40 years, the index oscillates around its long-term average of 85. Readings above the average represent consumer optimism and readings below the average represent consumer pessimism, mainly as it relates to their financial well-being and their view of the broader economy.

Sentiment data is a valuable tool in the financial community for assessing consumer well-being amid the current economic climate. Tracking its overall trend offers insights into consumer contentment and how consumer behavior might impact economic growth in the near-to-medium term. An upward trend suggests positive consumer sentiment and sustained consumption, while a downward trend signals growing concerns about future economic conditions, possibly leading to more conservative spending behavior.

Additionally, sentiment data is crucial for identifying market condition extremes. High optimism in consumer sentiment can indicate overexuberance, acting as a contrarian signal for potential market peaks, whereas extreme pessimism, often during economic downturns, can signify a nearing upturn in market conditions.

In our previous discussion, we examined the sentiment data as of the final quarter of 2022, noting that the sentiment index was at a relatively low level, indicating extreme pessimism, yet showing signs of potential improvement. We analyzed these extremes in sentiment against the corresponding returns in U.S. Equities over the following twelve months.

*Source: University of Michigan: Consumer Sentiment, NYSEArca, Analysis by RQA*

As illustrated above, the overall sentiment was markedly low (around 50) in September 2022, a significant multi-year trough. This pessimism was largely fueled by high inflation, rising interest rates, and a tightening monetary policy, which collectively cast a negative shadow over the economic outlook. We highlighted that such low sentiment levels often present contrarian opportunities, and in this case, the September consumer sentiment low presented investors with a particularly good buy signal for risk assets.

Our updated graphic below expands on this analysis, incorporating more recent sentiment data and updating the forward returns from the September 2022 sentiment low. It reveals that the September reading did indeed mark a significant low in consumer sentiment. Importantly, this period was followed by a notable upswing in the U.S. Equity market, with the S&P 500 Index climbing over 20% in the subsequent twelve month period. This demonstrates that leveraging pessimistic sentiment as a contrarian signal to invest in risk assets was particularly effective during this extreme phase.

Reflecting on the current absolute levels and overall trends of the sentiment index, a reading near 80 doesn't quite hit either extreme of the spectrum, though there has been a marked shift towards positivity recently. This upward trend in short-term sentiment aligns with other leading economic indicators, suggesting a shift towards a more optimistic outlook. Factors like a supportive U.S. growth environment, low unemployment, and easing inflationary pressures contribute to this more positive consumer stance.

As noted above, monitoring the trends and extremes in consumer sentiment can be a powerful tool. As optimism continues its ascent, it's crucial to watch for potential extremes, especially if the index approaches or surpasses the 100 mark, signaling an overly optimistic level.

Economic Forecast Model

The RQA Economic Forecast Model rebounded higher in December, jumping from 0.24 to 0.38 month-over-month. In our view, this marked move higher indicates more momentum behind the budding growth trends that have been emerging in recent months.

*Source: Analysis by RQA. Data from U.S. Federal Reserve; Bureau of Labor Statistics; Norgate Premium Data; Institute for Supply Management*

The RQA Economic Forecast Model represents a consolidated composite of key economic leading indicators and market-based explanatory variables. The goal of this composite model is to present a holistic measure of primary U.S. economic growth drivers and their trends over time. (Additional detail on the model’s construction is provided here.)

Values above the zero-line are indicative of positive U.S. economic growth expectations in the near-term, and therefore, indicate economic strength and lesser chance of recessionary pressure. On the other hand, values below the zero-line represent the opposite - a more negative outlook and more elevated probabilities of the U.S. experiencing an economic contraction.

TAKING A CLOSER LOOK AT THE ECONOMIC DRIVERS

In the economic heatmap below, we are able to peak under the hood at a wide mix of underlying growth drivers in the U.S. economy. By reviewing this underlying data in more detail, we are better able to see how the underlying components of the U.S. economic growth picture are behaving through time. The indicators presented below have each proven to have predictive qualities in estimating the future direction of U.S. economic growth.

The growth-oriented momentum seen in U.S. economic data continues to stem from a resilient U.S. labor market, continued growth in personal incomes and consumption, new year-over-year growth in residential real estate permits, and strength in service-oriented sectors of the economy, while growth in goods-related sectors continues to be challenged. As a continuation of recent trends, momentum in financial market leading indicators, namely credit/bond spreads, equity market bullishness, and resilient consumer and investor sentiment continue to point toward positive expectations on the U.S. economy.

MARKET REGIME DISCUSSION

Year-end has been marked by a surge in optimism, buoyed by positive investment flows and hopes for an economic soft landing. With the advent of the new year, consumer sentiment has rallied, overshadowing previous concerns about growth and valuations. The Federal Reserve's stance remains somewhat accommodative, contingent on favorable inflation data. Although, expectations for rate cuts are being pushed further into the future.

The RQA Economic Forecast Model recently hit a 20-month peak, indicating sustained near-term growth. This uptrend is supported by a strong labor market, relaxed financial conditions, and improving consumer sentiment, all contributing to the rise in leading indicators.

Inflation has remained relatively stable, hovering slightly above the Fed's 2% target. Looking ahead, opinions on future price levels diverge. The prevailing sentiment suggests that the rate hikes have sufficiently cooled the economy, projecting a continued decline in inflation, potentially dipping below the target. Conversely, a growing faction of market participants worry that the Fed's pause might be premature, and fear that the economy's strength and existing liquidity could fuel a resurgence of inflation, reminiscent of the 1970s scenario. Both perspectives present compelling cases.

Economically, as illustrated in the graphic below, it is our assessment that the U.S. is positioned in the 'inflationary boom' quadrant. Monitoring these inflation and growth trends will be important for strategic portfolio reallocation as the economic landscape evolves.