Markets Economy Portfolio Management July 2023
The S&P 500 Index finished higher by 16% for the first half thanks to a handful of secular growth stocks. The Invesco S&P 500® Equal Weight ETF finished just shy of 7%. In June, the stock market, measured by the S&P 500 Index, rose more than 20% from its October 2022 low confirmation a new Bull market is underway. Albeit it a concentrated Bull market with a small part of overall market racing ahead. A study by Capital Group concludes that concentrated market rallies in the past have often been followed by steady gains for the broader market. I favor investing in reasonably valued areas of the stock market that are trailing such as U.S. Mid-to-small cap stocks. Those areas may catch up as the consensus call for an outright recession fade. The U.S. Fixed-income market, measured by the iShares Core US Aggregate Bond ETF, is up 2.26% year-to -date. This time last year it was down significantly.
History shows that a strong first-half with gains of ten percent plus have been followed by additional 8% gains in the second half 82% of the time since 1945 according to CFRA research. Moreover, S&P 500 forward returns are positive after inflation has peaked as widely reported by news outlets such as Bloomberg. Inflation has clearly peaked and is moving lower. Lower future inflation allows for higher stock valuations. That is exactly what happened in the first half. Price action has discounted improving inflation numbers, an end to rate hikes coming soon, and now a possible economic soft landing. Investors are looking beyond the seasonally weak third quarter to a re-acceleration in earnings over the next twelve months. A softer economic landing would be required for fundamentals to support the Bull case. An end to the Fed tightening cycle this quarter could support this kind of outcome.
In the past, when the Fed stopped its tightening cycle, the S&P 500 Index rose over the next 12 months 92% of the time since 1950 according to Bank of America. The forward returns for the S&P have been above average over a 12-month period. My view is twelve months from now the US economy and earnings should be accelerating not decelerating like now.
Will there be smooth sailing ahead? That depends on core-inflation’s path and the Federal Reserve’s reaction. Core -inflation is moving lower, however it is significantly above The Fed’s target rate that the Fed obsesses about. Further tightening that is unnecessary could bring about the much-anticipated recession. Something investors should keep in mind is that Bear markets usually bottom mid-point in a recession. That should make investors cautious if a recession is coming our way. Widely circulated research shows that an inverted yield curve has preceded every U.S recession since 1950. Today’s yield curve is steeply inverted. Last time it was this inverted was in the 1970’s, another period of high inflation and recession according to DOW Jones Market data. Recession warnings have not completely gone away. Those calling for a recession are venerable institutions such as The New York Federal Reserve. Yet the stock market is signaling a soft landing. Which one is it? I side with a softer landing if the Fed does not continue to tighten after July.
Historically a fast-tightening cycle resulted in a recession, particularly ones that had five hundred basis point increase in rates like this one. Leading Economic Indicators (LEI) have been down for 14 months in a row – another red flag. Global PMI index sending recession warning messages. Credit spreads widened but have backed away from recession levels as talk of a credit crunch disappeared from headlines. Anyone professionally managing money had to take heed and be concerned about monetary lag effects on the economy. I see the economy slowing down the rest of year along with inflation indicators.
My view is any slowdown will not be as pronounced as in past tightening cycles because unemployment is not expected to rise as much as in past slowdowns. Why? For one, there is a shortage of workers. Secondly, corporations and households seized on the opportunity to borrow long term at historically cheap rates. The economy has had time to adjust to a normalization of interest rates. Fed Funds Rate rose from zero to short term rates associated with an economic expansion. Lastly, the Federal Government is still stimulus spending with the Inflation reduction act, etc.
Corporate profits have declined a lot less during recessions in times of high inflation according to research by Credit Suisse. Inflation indicators are steadily declining. Wholesale inflation, as measured by the Producer Price Index, is falling faster than it rose and is at its lowest level in three years. Business profit margins have held up because of lower commodity input costs.
Earnings reported better-than-expected results last quarter. FactSet reports that the second quarter has seen the highest number of S&P 500 companies issuing positive earnings guidance for a quarter since Q3 2021. CFRA research reports that census operating earnings are projected to bottom this quarter, and gradually rise over the next twelve months. If correct, the Stock market bottom is in because past patterns show prices bottom before earnings bottom. It may take a couple of quarters for earnings to re-accelerate because of the lag effect on monetary policy on economic growth. Earnings acceleration allows higher stock valuations.
Presently, the S&P 500 Index is trading at 20.3 forward earnings (year-end). That is lofty unless the economy is heading for a soft landing. The odds of a soft landing characterized by flatter economic growth are rising, which would benefit corporate earnings. Stable consumer consumption and lower levels of unemployment, thanks to structural labor shortages, are also supportive of corporate earnings. AI is another tail wind for profit margins. It is an offset to wage inflation hit on profit margins. Lastly, corporate profit margins remain robust compared to historical metrics. The latest decline in the Producer Price Index continues to support higher profit margins.
The time to overweight equities is early cycle when the Fed is done hiking. We are so close to an end to this tightening cycle. The speed, magnitude, and duration of tightening cycle suggest the Fed should be done in July. The lag effect of monetary policy has already hit "goods", "commodities", and into year-end “services” should feel it. The market is in the third year of the presidential cycle, which is the best year for stocks in its cycle. Typically, there is third quarter weakness followed by a strong fourth quarter. Inflation data clearly shows peak inflation. Historically, S&P 500 index returns are usually positive after inflation peaks. I am overweighting stocks this summer by dollar-cost-averaging into cyclical sector and Mid-Small cap stocks. Many areas of the stock market are overbought with stretched valuations. In the short term it does not matter. Finally, the Investment Company Institute reported a record level of cash is sitting on the sidelines parked in cash-equivalents such as Treasury Bills- plenty of dry powder is a bullish indicator.
The U.S. is currently in late cycle characterized by higher interest rates, rising inventories, and slower economic growth. The odds of a recession have considerably fallen but remain elevated as the effects of aggressive monetary policy filter through the economy. Consumption, which is 65% of the U.S. economy is quite healthy. However, consumer credit is growing at its slowest pace since May 2020. Bank lending is shrinking. The ill effects of tighter financial conditions weigh on future economic growth. Despite coming in better than expected, the Conference Board's index of Leading Indicators has declined for fourteen straight months - at level that has been associated with recessions in the past. The ratio of Leading to Coincident indicators has rolled over and is at five-year lows. Historically, that is a trend that has also been associated with recessions.
The U.S. economy grew at a 2% annualized pace in the first quarter, according to the Commerce Department. Upward revisions in consumer spending and inventories boosted the revised number. Consumer spending, as gauged by personal consumption expenditures, rose 4.2%, the highest quarterly pace since the second quarter of 2021. The recent figure undermines consensus expectation of a mild recession around the corner. The Federal government is spending more than it should to juice economic growth. It is running a budget deficit of $34 billion and continues to spend more than it brings in. The latest GDPNow model estimate for real GDP growth in the second quarter is 2.3%. Moody’s analytics baseline forecast for 2023 and 2024 is economic growth projected to be 1.7%, and 1.1% - lag effects kicking in but no recession.
The US economy cannot slip into a recession with a job market as healthy as this one. Labor reports showed layoffs running well below expectations, indicating that labor market strength has held up even in the face of the Federal Reserve’s interest rate hikes so far. There currently are about 1.7 open positions for every available worker. Unemployment remains extremely low at 3.6%. The labor market is a lagging indicator. Excess labor supply is dwindling. Continuing claims are modestly rising. Even so initial claims, one the better leading indicators of a recession, are not even close to a recession warning. The economy needs 360,000 plus weekly initials claims to say economy is in a recession. The Department of Labor’s most recent report shows the 4-week moving average was 246,750.
Low unemployment is boosting personal income and consumption that normally would be lower after one year of rate hikes. Moody’s Analytics says an 8.7% boost in the Social Security cost-of-living adjustment propped up consumer spending figures. Wages continue to rise at a slowing pace, but after inflation wage growth gains are wiped out by higher cost of living. Families cannot buy the same basket of goods and services before inflation took off to a 40 year high, and cost of debt services is rising.
Higher interest rates are not hitting as fast and hard as in the past as a bulk of households and corporations have refinanced at fixed lower rates of about 3-4%. Housing, an extremely sensitive interest rate sector, is particularly strong in housing construction. The travel and hospitality sectors are hot. The labor market is healthy with workers experiencing nominal income growth supporting consumption.
There also was some good news on the inflation front. On a y/y basis, headline inflation dropped to 3.0%, the lowest level since March 2021 while core CPI dropped to 4.8, which is the lowest reading since October 2021. Inflation is lower than CPI reports because shelter cost is its biggest component and it a lagging input. It is being reported as being higher due to the data lag. Shelter cost is declining. The tightness in Labor markets is still causing wage inflation albeit at a slowing pace. Wage growth has not kept pace with inflation.
Recessions are associated with fast tightening cycles. This tightening cycle is one of the fastest ones. Studying past tightening cycles shows that five hundred basis points of hikes have always led to a recession. This time seems be different because the Federal Reserve is hiking from a zero rate, ultra-stimulative, not from a more common Fed Funds rate in the single mid-digits. Tightening so far has successfully drained the excess cheap money from the economy, caused most inflation indicators to dramatically moderate from 2022 levels, and restrained growth. The US economy could escape a recession because the Federal Funds rate is not excessively constraining growth like in past recessions. It is closer to historical levels associated with slow economic growth. With unemployment so low and core-inflation way above the Fed target rate, I expect the Fed to hike again this month and not cut this year. The Fed actions to keep rates higher for longer will grind away on employment and slow down wage growth. The direction of inflation into year-end supports a soft-landing scenario unless the Fed continues to hike beyond July.
The Fed will have a challenging time raising the unemployment rate because workers lose their jobs and find another in the current cycle. At this point, the Fed should solve the problem of inflation not by destroying demand but by providing a supply side solution.
The late-cycle economic phase with declining risks of garden variety recession calls for a balanced diversified portfolio with a tilt to cyclical stocks. With the Federal Reserve nearing the end of its tightening cycle and a resilient US economy pushing out any recession, an asset allocation that addresses both slower economic growth and a reacceleration in future earnings is the way to position a portfolio at this stage of the market cycle. Primarily, when the Fed stops tightening then historically it is time to buy stocks, Long-term Bonds, and not Treasury-bills. Typically, stocks and bonds have outpaced cash after a Fed hiking cycle ends.
Stay balanced, own both stocks and bonds. Bonds offer an attractive risk-adjusted return based on the earnings-to-yield ratio comparison. Higher yields mean that bonds are generally better equipped these days to dampen equity market volatility. Moreover, higher income from bonds also means higher returns. Bonds have tended to recover strongly after rate increases end. Whereas stocks could provide capital appreciation that outpaces inflation as the headwind of rate hikes end.
The Citigroup Economic Surprise Index has been positive for most of the year, historically bullish for cyclical sector leadership. Strong consumer spending and low unemployment could help push off the start of the recession into 2024. Consumer sentiment is improving, a good sign spending may continue even with the current level of interest rates. The University of Michigan consumer sentiment for the US increased in July to the highest level since September of 2021.
U.S. Large-cap stocks have higher valuations and PEG ratios (Current Price/Projected EPS Growth) along with all sectors outperforming this year such as Technology and Communications Services. Higher large-cap valuations imply that company earnings must grow over the next 12 months for the S&P 500 Index to rise. U.S. Small-cap stocks and U.S. Mid-cap stocks are areas of the market not selling at expensive valuations. Earnings growth expectations are set much lower and it is easier to clear the bar. I am investing in U.S. Small-cap stocks. Moreover, in the past U.S. Small-cap stocks have outperformed U.S Lage-cap stocks when the S&P 500 Index has outperformed by this much year-to-date coupled with exceedingly high concentration level in the S&P 500 Index according to NDR.
Wall Street analysts project the S&P 500 Index to rise by 9% over the next 12 months according to FactSet. The bottom-up target price for the S&P 500 is 4823. At the sector level, the Energy and Health Care sectors are expected to see the largest price increases. Whereas the sectors that have led the market in the first half of 2023, Technology and Consumer Discretionary, are projected to produce the smallest price increase. Energy and Healthcare are tactical positions portfolios that I am maintaining.
I am holding onto an overweight position in secular growing Technology stocks. Technology stock valuations tend to rise after Fed Funds Rate peaks. If there is a cut in rates sometime in 2024 because core-inflation is trending towards 2%, then Technology valuations are likely to see a further boost in valuations as interest rates fall. Moreover, if the recovery in 2024 is anemic then growth stocks should outperform on a relative basis over cyclical value stocks. There is a risk that any recovery in 2024 may be weaker if Fed keeps rates higher for longer. Normally, stronger recoveries are associated with a tailwind of easier monetary policy.
Small-cap stocks are more sensitive to changes in economic conditions. Many of them are more susceptible to tighter credit conditions that are associated with downturns. The recent regional banking crisis has held them back. Tighter credit makes it harder to refinance existing debt. Small caps were discounting at least a slowdown or a mild recession. Small caps start outperforming when credit spread begins to tighten and yields peak. Both conditions are forming now. Small caps may outperform over next twelve months given economic growth remains positive, interest rates peak in July, and credit spread narrow. The U.S. economy could be transitioning from late stage, a rolling sector by sector recession in 2022, to an expansion in 2024. If the prospects for a soft-landing pan out, then I expect Small- caps to outperform expensive defensive Large-cap stocks over the next twelve months. It has been said that Small Caps lead stocks out of a recession.
When Fed Funds Rate peaks it is time to buy foreign developed markets equities. Generally, the U.S. dollar peaks as rates peak. The US dollar peaked and has been trending lower over the past few quarters. A declining dollar favors foreign equities over US equities. I am moving from an underweight to neutral position in developed foreign equities. I remain underweight in Emerging market equities because of the geopolitical risks surrounding China. My strategy to buy emerging market equities ex China ETF. I have enough exposure to China in accounts through Apple and other multi-national companies.
Maintaining quality positioning in bonds even though a garden variety recession does not seem to be unfolding. There is still credit risk as fundamentals could deteriorate under a higher for long-term interest rate regimes. What is more, if growth slows, high-quality bonds have tended to provide the important benefit of diversification from equities. If a recession does occur, more investors could turn to bonds in search of relative stability and income.
Schwab research points out that intermediate term bonds have outperformed short term bonds after a peak in the Fed funds rate since 1974. Shorter-term fixed income has greater reinvestment risk. However, based on Chair Powel’s recent comments, reinvestment risk should be low for 2023. Fed has no intention to cut rates this year. I have an overweight position in short end of the yield curve and gradually overweighting long-term bonds which would begin to outperform when Fed is finished hiking.