Weekly Investment Update (04/19/2024)

This week, Fed Chair Jerome Powell had a new message for markets — it might take longer than expected to initiate rate cuts. Whether this ends up holding true will be determined by future employment and inflation data, but even recently hotter-than-expected reports show progress toward the Fed’s 2% inflation objective, and we are inclined to look through some of the headline noise. In the March CPI report, for example, three of the four major core categories (which represent 92% of the weight in core) were at or below prevailing 3- and 6-month trends. Although the monetary policy waiting game may cause short bouts of market volatility, the U.S. economy appears strong enough to endure an extended rate pause. As earnings season begins, we will be watching for any signs of material weakness in growth expectations but believe the earnings picture will continue to provide fundamental support. We acknowledge the increase in geopolitical risk after Iran’s recent attack on Israel, although we don’t expect Israel’s response to generate a material escalation. It is telling that Brent crude oil prices are down over 5% from recent highs. Perhaps most importantly, we believe the “Fed put” is alive and well as the Fed has ample room to ease from current rate levels if necessary.

Bank Earnings Continue to Depict a Divergence in Consumer Strength

What is happening: The largest U.S. banks have started to report their first quarter earnings, providing insight into current economic conditions and the state of the consumer. Banks broadly have reported strong earnings with 80% beating consensus expectations. Given that interest rate expectations have evolved over the past several months, net interest income, or the profit banks earn from charging higher interest rates to borrowers than they pay out to depositors, has been a key focus for investors. Though some banks guided toward weaker net interest income than the market anticipated, large banks, such as Bank of America and JPMorgan, which tend to enjoy more diversified sources of revenue, saw increased capital market returns driven by improvements in investment banking income as merger and acquisition activity picked up. While the overall consumer has remained healthy, net charge-offs, or debt owed that is unlikely to be recovered, have increased as the lower-income consumer is pressured by elevated interest rates.

Why it matters: While the overall economic environment and consumer have been resilient, there are potential risks to consider. Many economic indicators continue to be favorable, but uncertainties in the global landscape can weigh on economic conditions. While we believe consumption will remain healthy, we do foresee a slowing in some areas. For example, as pressure builds for low-income consumers, some signs of consumer tradeoffs are emerging, such as substituting spending on discretionary items with non-discretionary items.

Overall, consumer spending trends remain solid, supported by a resilient labor market. Additionally, stronger-than-expected retail sales results will likely lead to upward revisions in consumer spending for the first quarter, which should boost growth expectations. The Bessemer All Equity Portfolio is underweight the banking sector relative to benchmarks, especially within the small capitalization range. Bessemer portfolios have exposure to high-quality banks such as JPMorgan and Bank of America.

Higher Motor Vehicle Premiums Contribute to Sticky Inflation

What is happening: The cost of auto insurance in the U.S. has risen, on average, more than 22% in the 12 months preceding March — the biggest annual jump since 1976 and a key contributor to recent inflation data. Motor vehicle insurance alone accounted for 16% of the overall increase in the most recent Consumer Price Index (CPI) reading of 3.5%.

The surge in automobile insurance premiums can be attributed to many factors, with the escalating cost of vehicles being the most significant. Since the onset of the pandemic, new vehicle prices have increased by an average of 21% with used car prices increasing by 29%. This trend has significant implications for insurance providers, as they are responsible for covering the cost of replacement vehicles. The increasing complexity of cars has also contributed to higher repair bills.

Modern vehicles are equipped with more electronics than their predecessors, including multiple cameras and proximity sensors on bumpers, pushing up the average cost of repairs. This is particularly true for electric vehicles (EVs), which typically cost more to repair and, therefore, to insure than traditional combustion engine vehicles due to the complex technology and expertise needed for EV repairs. A shortage of skilled mechanics has led to wage pressures and longer lead times for repairs, resulting in a higher cost to insurers who provide loaner cars to policyholders while their vehicles are in service. Weather related events, including tropical storms, floods, and wildfires, caused over $1 billion in auto related damages last year, leading to higher claims in states such as Florida and California. Lastly, traffic levels have returned to pre-pandemic levels, resulting in a rise in claims as the likelihood of accidents typically increases with more cars on the road.

Why it matters: Over the past four months, headline inflation has consistently exceeded expectations, driven by persistent price pressures in the services sector. The latest headline inflation figure showed a year-over-year increase of 3.5%, above the Federal Reserve's target of 2%. However, we see evidence that price pressures are moderating. In the past year, new and used car prices have remained largely unchanged as demand has weakened and supply chains have normalized following the pandemic. In our view, motor vehicle insurance is likely to moderate from current levels, which will help ease inflation pressures. The Federal Reserve’s preferred measure of inflation, Personal Consumption Expenditure (PCE) has a lower weighting to vehicle insurance than CPI.

Recent speeches from Federal Reserve officials have emphasized the importance of building confidence in achieving a sustainable path toward the 2% inflation target before considering rate cuts. At the March policy meeting, officials continued to predict three rate cuts in 2024, though FOMC members were divided between those expecting two cuts and those expecting three cuts. Market expectations of the probability of a June interest rate cut now stand at 15%, down from 50% at the beginning of April. Bessemer's analysis suggests that overarching disinflationary trends persist, supporting the notion that while the path to reaching the Federal Reserve's inflation target may be bumpy, it is likely to pave the way for rate cuts to begin later in the year.