Optimism has been in ample supply lately. Even the financial media has started jumped on the bull train!
It’s understandable – as of June 16, the S&P 500* is up roughly 15% so far this year (not including dividends) and up about 23% (without dividends) since bears reigned back in October 2022. This performance, along with the Federal Reserve’s pause in interest rate hikes, has the media seeing roses and rainbows. There’s a belief the coveted “soft landing” of inflation relief without a big economic slowdown can happen.
But recession is still possible.
If monetary policy is tight enough to fix inflation, it will inevitably slow economic activity. Regardless of how you define a recession or economic contraction, the odds of one remain above zero.
Let’s think about this from a hockey perspective – as a skater (investor), you want to go where the puck (market) is headed. Unfortunately, the Fed has been doing the opposite for the past few years, hence our concern about achieving the “soft landing.” The Fed has been chasing the puck.
For instance, the central bank’s inflation target remains 2%. Well, the personal consumption expenditures price index (PCE), which reflects consumer price changes, is at 4.4%. If you look at the past 60 years, the only time the PCE inflation rate dropped as much as it will take to get to the targeted 2% was during or right after recessions.
Maybe this time is different. But it’s safer to be skeptical until we know for sure. Hope for the best but plan for the worst they say.
Our readers know we've consistently followed the M2 measure of money supply, which essentially measures the liquid money supply, after it surged unnaturally from 2020-21 due to COVID-19 relief. The figure has dropped significantly this year, which will eventually put additional handcuffs on the economy.
Additionally, recently released analysis from JP Morgan says that the household excess savings from the free money Covid period will likely be drained by the end of the year.
Also, initial jobless claims have increased recently. The uptick is increasing the four-week moving average (for perspective, these indicators haven’t been this high since late 2021):
Manufacturing indicators already show a recession. Meanwhile, service indicators show growth. We think that’s because services rebounded slower than manufacturing and thus have been slower to contract.
Perhaps a recession is imminent. Even so, it doesn’t mean the stock market is going to fall apart. Equity markets are forward-looking mechanisms. The German DAX, a stock index made up of 40 top German companies, provides a great example. The German economy is in a recession, yet the DAX just hit an all-time high:
Economies and markets cycle up and down. Obviously, we're not rooting for a recession. We want that elusive “soft landing.” But if contraction occurs, the DAX shows that equities can survive. It’s imperative not to get caught up on either side of the emotional pendulum.
Fixed Income Outlook
How does this outlook affect fixed income opportunities?
While the Fed’s 2% target inflation rate may seem like a pipe dream, the Fed governors and PhD’s see the cost of interest on our $32 trillion in national debt as potentially devastating. Interest payments on the federal debt are a “hockey stick,” almost doubling since 2020:
Inflation is moving in the right direction. However, there’s still a disconnect between luxury items and what the average U.S. consumer is facing.
For the “average” outlook, we turn to Home Depot CEO Ted Decker. He recently told CNBC he expected to see sales decline by 2%-5% in comparison to 2022 and earnings to fall 7%-13%. On the luxury side, ticketing company StubHub shows the cheapest average ticket price to see a Taylor Swift concert is $969 in sold-out venues, while the highest price averages $20,503.
Some are flourishing as others languish. This is the cyclical nature of economics.
While the market rallied in the second quarter on the back of technology firms, stocks of specialty retailers tanked at the same time from bearish forward guidance. The SPDR S&P Retail ETF (XRT)#, an exchange-traded fund (ETF) that tracks retailers across several sub-industries, rose on the back of COVID-19 stimulus and fell on what looks to be a hunkering down for the average American:
Following the summer’s expected spending and travel spree, it wouldn’t be surprising to see more American belt tightening. This would likely affect the services economy as well.
It’s clear the Fed failed to recognize inflation’s full potential early on. The central bank is now committed to getting it right (if not, it may imperil the ability of the country to pay its debt).
But eventually, the Fed will finish orchestrating an economic slowdown aimed at lowering prices. This situation is creating fixed income opportunities for investors that haven’t existed in years.
Approximately a year ago, the 30-year Treasury was yielding about 3%; today it’s roughly 3.9%. If longer duration Treasury bonds return to 3% yields, it would provide a price return of roughly 15% from current levels (remember bond yields and prices move in opposite directions). We think such a move is viable due to the Fed’s determination to correct inflation.
Here’s another example. Using the riskier PIMCO 25+ Year Zero Coupon U.S. Treasury Exchange-Traded Fund (ZROZ)^ as a proxy, a move back in yield to 3.0% would theoretically produce a return of 21%:
So, there’s been a shift in the fixed income landscape. We’re beginning to support moving from all short duration bonds to longer-term durations as we eye our third quarter portfolio rebalances. Of course, that’s if the data continues to back longer durations within the bond market.
Equities Still Broadening
We're continuing to see equity market leadership broaden and it’s proving to be bullish. “Big money” investors continue to jump on small- and mid-cap stocks:
Our friends at MAPsignals produce the trusty Big Money Index (BMI), a 25-day moving average of “big money” investor buys versus sells. The buying action noted above sent the BMI upward to 66.3% as of this writing:
While the news is usually worrisome, stocks are rallying, and it’s causing a media about-face. For the first time in a while, we're seeing stocks from different industries and sizes move in correlation. This runs counter to the sideways, “trendless” markets of the last couple years. Now all sectors and industries are participating in the rally. Yes, technology has been leading, but other sectors are rising:
Since October 2022, tech has drawn the most buys, but other sectors are catching up:
Since the October 2022 lows, the pattern of buying is consistent, which indicates market shifts have been happening under the surface:
No matter where we look, we're seeing noticeable buying from “big money.” The party seems to be in full swing!
Not so fast – there are some signs of short-term consolidation ahead. But it’s nothing to fear. We bring this up in an attempt to skate to where the puck is going. As a reminder, we recently saw virtually no selling:
Perhaps more importantly, when examining ETF trading, intense buying usually indicates near-term tops. That’s what we’re seeing now:
It’s easy to see why the BMI is rising and how it could venture into overbought territory if these trends continue. Thus, a summer pause before the fourth quarter wouldn’t surprise.
Really the only worry left is the Fed’s stance on interest rates. The rate hike pause accompanied signals of potential future increases, allowing the Fed to have its cake and eat it too.
Despite Fed worries, the data shows a highly correlated string market. And the rate pause speaks volumes. So, let's focus on the positives for now.
With the third quarter approaching and our systematic rebalance near, we'll stick to our playbook dating to the start of last year, with tactical changes as we begin to go longer duration on bonds and rebalance equity positions and sectors in preparation for what’s ahead. In other words, we’re skating to where the puck is going.
*The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
# Neither Cornerstone Financial Services, LLC, nor Daniel Milan own XRT in any accounts.
^ Neither Cornerstone Financial Services, LLC, nor Daniel Milan own ZROZ in any accounts.
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Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial and CoreCap are separate and unaffiliated entities.