Markets, Economy, and Portfolio Management Update April 2023
The S&P 500 Index returned 7% for the first quarter and the SPDR Aggregate Bond ETF 3.23%. Semis conductor stocks are leading the market. Historically, when semis lead it is a bullish sign for investors. Historically, when the S&P 500 ended a quarter up so much it also ended the year higher according to BIG research. Markets are anticipating the end to rate hikes this year. Interest rates are the key to markets. Higher rates depress valuations across all types of assets, not just stocks and bonds affecting wealth, and consumption.
The market is trading at levels suggesting any recession ahead should be a mild one and inflation is heading lower. Despite risks of igniting a credit crunch, the Fed hiked the Fed Funds rate again in March, while hinting its hawkish tightening policy may be ending soon. Solvency and liquidity risks in Regional Banks appear to be easing for the moment, the Bank Term Funding Program has provided a stop gap liquidity to any Bank that needs it. However, there may be other regional banks that could have solvency issues by year-end if the Federal Reserve (Fed) does not stop its hiking regime. The Fed intends to hike by twenty-five basis points at its May meeting and hopefully stop. Fed officials see Fed Funds Rate unchanged from next month’s hike for the remainder of the year. Let us hope the Fed does not repeat its past mistakes of hiking until “Regional Banking” sector totally breaks. U.S. banks are sitting on loads of unrealized losses from bonds due to Fed rate hikes and the Fed will not stop hiking making the situation worse and driving economy into a recession. Bank tighter lending standards could replace any rate hikes. Tighter financial conditions will stall economic growth and ease inflationary pressure.
The Fed Funds rate level is just as important as earnings for equity valuations. Interest rates change the value of all assets and are brakes on economic growth. If interest rates peak this May, then forward valuations will rise in the future as the market anticipates a bottom in earnings and re-acceleration as the Fed cuts rates to end recession. It is all about interest rates now. Historically, valuations start rising at about mid-point in recession even as earnings decline due to tighter financial conditions. By then interest rates will have long peaked and yields historically fall allowing for future earnings to accelerate. Lower interest rates support higher consumption, higher earnings, and in turn higher valuations. Restrictive monetary policy is a headwind for stock earnings until the Fed is finished hiking Fed Funds Rate. Forward equity returns following recessions are positive according to Blackrock research.
U.S. broad stock market indexes are expensive, and earnings are coming down. Even so the stock market could rally when interest rates peak. It is all about the level of interest rates. Higher rates less liquidity, lower earnings, lower valuations in security prices and other assets and vice versa. When interest rates peak forward valuations start to expand anticipating bottoming in earnings then a re-acceleration in earnings as rates cuts follow. That is the cycle ahead for investors this year. A re-test of October’s bottom could happen based on further tightening by the Fed and on lagging effect of tightening finally hitting economy. I think any re-test would be short lived and bought by investors.
The U.S. is currently in a late cycle but a recession this year appears likely. Higher interest rates are weakening consumer demand, making it more expensive to live, and now contributing to bank failures. Household debt/service payments as a percentage of personal income is rising – Household operating cost rising! Chicago Fed National Financial conditions at tightest levels since May 2020. Credit spreads were widening early March over worries of more regional bank failures and have come off their highs. Wider credit spreads are an ominous sign of a recession on the horizon. The Fed’s aggressive tightening campaign is working. Liquidity that contributes to inflationary pressure is rapidly being drained from the U.S. economy. The supply of money is declining at the fastest pace since the Great Depression. Apparent end-of-cycle dynamics exhibiting themselves include slowing economic growth, rising inventories, declining profit margins, tightening credit conditions, contractionary monetary policy, rising unemployment claims, and inflation is moderating.
Inflation continues to moderate as the Federal Reserve’s interest rate hikes slow economic activity. In March, the Consumer Price Index (CPI) rose 5% from a year ago, far off its 40-year high of 8.5% last year. Many indicators such as import, and export prices are declining faster than they rose. Producer Prices paid plunged in March to a year-over-year rate of 2.7%. The personal consumption expenditures price index excluding food and energy, the Fed’s preferred inflation indicator, rose less than expected in February. On a 12-month basis, core PCE increased 4.6%. Shelter costs, which make up about one-third of the CPI index’s weighting, could be peaking. The Federal Reserve expects housing costs and rents to slow over the course of the year. Housing costs are a key driver of the inflation figures, but they are also a lagging indicator. Overall, a CNBC survey reports Household budgets are really being squeezed by inflation. 1 Year TIPS Breakeven show the Fed being successful at bringing down inflation over the next twelve months, which bodes well for a rate cut by 2024 or sooner depending on the level of inflation. Lower inflation over the next twelve months supports consumption, Fed rate cuts, and a smaller decline in corporate profits.
The late-cycle economic phase with high risks of recession calls for a balanced diversified portfolio. With the path of the economy either slipping into a mild recession or narrowly averting one, an asset allocation that addresses both recession scenario and slower economic growth is the prudent approach. However, investors cannot ignore the end to this tightening cycle and the opportunity for future growth. There are reasons not to be overly risk off and invests entirely for a recession only. After a recession comes the early cycle recovery which has historically yielded strong U.S. equity returns.
Bonds offer better risk-adjusted returns than S&P 500 Index (large-cap U.S. equities) for the time being given the risks to earnings and S&P 500 Index forward valuations. However, long-duration assets such as equities and long-term bonds post positive forward returns when interest rates peak. In a recession long term bond prices rise. I am investing in long term investment grade bonds, and selectively investing in quality dividend growing stocks in both defensive and cyclical sectors that are trading at reasonable valuations. Dividend stocks outperformed the S&P 500 Index market by 4.5% during the 2001, 2008 and 2020 recessions based on research by UBS.
I have a laddered approach towards bond component management. Assets are spread across short-term bonds, intermediate bonds, and long-term bonds. Recent bond investments have a bias towards long term bonds. Investment grade bond prices fell about 30% last year. Those bonds mature at par offering opportunities for capital gains. Meanwhile, the yield on those bonds exceeds 5%. Bond investing prior to a final rate hike has provided positive bond returns, as measured by investing in the Bloomberg US Aggregate Bond index, a proxy for the US Bond market. There were six tightening cycles over the last forty years. Investing in bonds using a dollar-cost-averaging strategy over 12 months, six months before the final rate hike, would have returned a range of 3.3% to 10.2% in the first 12 months. Annualized returns over five years range from 5.9% to 15.6% according to research by Capital Group.
Investment grade long term bonds are a better recession hedge. Long Treasuries offer protection against stock market declines caused by caused by a recession. Treasury bonds have outperformed Treasury Bills during deep recessions in the past twenty years according to Morningstar study. Even though long-term bonds yield less than short term bonds, investors profit could be higher based on price gains from long term bonds that short term bonds cannot provide to investors when the Fed eventually cuts rates. Since 1974, intermediate-term bonds outperformed short-term bonds after the peak Fed Funds rate according to Charles Schwab research.
What areas of the stock market are attractive to me? Areas in the market and individual equities that are trading at more reasonable forward multiples. Foreign stocks for one, Healthcare, Energy, selected Financials, and US Small-cap. US Small-cap is economically sensitive, however, US Small cap’s valuation has discounted a slowdown. If lower inflation allows the Fed to wrap up its tightening cycle while the economy and job market are not in recession, cyclical sectors would be the outperformer over defensive sectors. Moreover, U.S. Small caps lead equity markets on the way out of a down market after yields peak. Rate volatility is expected to decline this year. As it declines U.S. Small caps should catch a bid.