Oct 09, 2023
Soft landing, hard landing, no landing. What would Wall Street and the investment world do without similes, metaphors, narratives, and tales? When it comes to landings, we think they are better suited for airplanes, not economies. And as for tired metaphors, landings tell us nothing about what happens next.
The following is a compendium of key issues that we believe are driving the current and future investment environment. They derive from the ongoing, disciplined application of our equity and bond selection processes, our independent macro analysis process, and our comprehensive risk management process.
A Challenging Quarter for Stocks
The stunning market performance of the first half continued into late July, when a group of seven technology-related mega-cap stocks began to show fatigue in carrying the rest of the market on their collective backs. The combination of Alphabet (Google), Amazon, Apple, Meta (formerly Facebook), Microsoft, Nvidia, and Tesla gained 53.0% while the remaining stocks in the S&P 500 gained 1.2% for the nine-months year-to-date. The pullback in stocks in August and September was more widespread, affecting all sectors and market capitalizations, with the exception of the Energy sector.
In the 3rd quarter, the S&P 500 generated returns of -3.3%, bringing the year-to-date results to 13.1% and the Dow Jones Industrial Average generated quarterly and YTD returns of -2.1% and 2.7%. Stronger than expected economic growth in the 3rd quarter became a more complex issue for investors. Consensus thought was becoming more comfortable with the no-recession scenario. However, the prospect of interest rates staying elevated for a prolonged period introduced a different set of concerns for the economy. Significant risks to the economy discussed below keep the prospect of recession very much on the table, albeit arriving later than once thought. From our perspective, no amount of crystal ball gazing offers much clarity and compelling investment ideas will require more discernment and patience.
3rd Quarter Observations
Interest Rates: Rates continued to rise and the yield curve shifted significantly higher, especially for maturities 5 years and longer. In a move reminiscent of June, the Federal Reserve once again opted not to raise interest rates, leaving them at 5.25%. The consensus now expects at least one more increase.
Inflation: The rate of inflation growth has declined meaningfully from its 9% peak reached in 2022. But even the most recent report of 3.7% inflation is too high for the Fed to relax its tight policy. Despite a slower inflation growth rate, prices remain meaningfully higher than pre-pandemic levels, weighing heavily on consumers, especially in lower income categories who think more in terms of dollars and cents than rates of change.
Government: The end of the 3rd calendar quarter also marked the end of the Federal Government’s fiscal year which once again brought concerns about a government shutdown. While this was narrowly averted for now, the overhang of this type of activity is potentially disruptive to the economy and investor sentiment.
Housing: The average rate for a 30-year fixed rate mortgage currently stands at 7.4% in contrast to 3.1% two years ago. Similarly, the average rate for a 5/1 ARM mortgage currently stands at 7.1% compared to 2.8% two years ago. Nevertheless, the inventories of new and existing homes remain tight despite prices that are up 20, 30, or 40 percent in some markets, making home prices unaffordable for many.
Consumer Spending: Oil prices in the U.S. have increased by over 29% per barrel since the beginning of July. As a consequence, the average price of a gallon of gasoline at the pump has risen over 7% during the same period, currently standing at about $3.80 per gallon. This, coupled with the resumption of student loan repayments, and growing credit card balances at much higher interest rates, are developments that may challenge the resilience of consumer spending.
Debt and Rates: High debt levels for all borrowers, especially federal, will keep upward pressure on interest rates. As the Fed is no longer a net buyer of Treasuries and with the Treasury issuing large quantities of bonds to pay for government spending programs, bond yields will need to be high enough to entice investors to participate. The combination of higher rates and historic debt levels is creating an alarming increase in debt service costs to the government. Funding costs have also risen for corporations and consumers, likely meaning slower activity ahead and perhaps margin pressure as well. At the same time, tax receipts have declined and the recent downgrade of our government debt means we will all pay more to borrow money.
Energy Economics: To many this is a political hot potato. To us it is pretty straightforward. Whether your vehicle is powered by gas, diesel, or batteries, it now costs significantly more to drive. Far more impactful for the long term, however, is that companies and countries have seriously underinvested in both maintenance and capital expenditures to support overall economic growth. The implication is tighter supplies and therefore energy prices remaining higher for longer. The same is true for the mining sector which has implications for the transition to electric. We have woefully underinvested in the electrical grid in the United States.
Geopolitics: Three points with respect to the Russia Ukraine War and China. First, the war remains a global risk, even though it garners fewer daily headlines. It remains costly in human terms, financial terms, and it is taking place in one of the world’s breadbaskets. Second, China is determined to be a more influential player on the world stage while at the same time turning inward in their relationships with trading partners. With global supply chains diversifying, costs for manufacturing will be higher. Third, the risk of an “incident” rises when the rhetoric between the U.S., Russia and China heats up.
U.S. Politics: Investors will be keenly focused on upcoming elections and the political climate over the next 13 months. Of the myriad of major issues that differentiate the political parties, some will have a more direct impact than others on markets and the economy by the nature of their direct impact on corporate earnings and investor psychology. The uncertainty of outcomes and the acrimonious backdrop will likely weigh on the markets.
Summary and Outlook
Early-year prognosticators pointed to historically reliable indicators and warned of an imminent recession. A common explanation for missing this call was underestimating the lingering effects of government stimulus. The 525 basis points of rates hikes have not yet had the impact on the economy as expected.
The no-landing crowd points to low unemployment, rising wages, slowing inflation, nearing the end of rate hikes, improving supply chains, and stronger corporate earnings performance. There is also a case that the broad market’s valuation is more attractive than it looks due to the distortion caused by the handful of mega-cap tech-related companies. The weakness over the past two months is driven by the markets adjusting to the expectations of the U.S. business environment, now facing a materially higher level of inflation and interest rates. Unprecedented in financial history, the size and speed of these changes have yet to be fully absorbed by the markets. As such, we are inclined to lean cautiously at this late stage of a most unusual economic cycle.
Beyond this shorter/medium-term outlook, we are encouraged by the potential of a new wave of innovation and ingenuity that should have significant impact on productivity enhancements. We hope to be spending more time addressing these opportunities with you in future correspondence.