Last week’s market action personifies the ‘Goldilocks’ backdrop with the Dow rallying +2.1% (riding a 10-day winning streak to boot), the S&P gaining +0.7% (now just 6% of record highs), and the Russell 2000 climbing +1.5%.  The Nasdaq experienced a rare dip of -0.1%, though it remains up +34% on the year.  The fact that the Invesco S&P 500 Equal Weight ETF is up more than +9% on the year illustrates the broadening out in market participation beyond the Magnificent 7 over the past seven weeks.  It was as recently as the end of May that the equal weight index was pretty much unchanged from the start of the year.  So much for the laundry list of worries that was supposed to represent a stiff headwind to equity returns in 2023: ongoing Fed tightening, the Russian-Ukraine war, the U.S. – China conflict, a lackluster economic follow through on the China reopening trade, elevated recession risks (according to some indicators), and a supposed banking crisis. 

Let this serve as a good lesson regarding the importance of investor sentiment and positioning on asset prices.  It’s not as though the above-mentioned laundry list of worries weren’t legitimate risks (they were/are), but all of them were well known and therefore discounted into asset prices coming into the year.  It’s for these reasons that investor sentiment and positioning were extremely negative coming into the start of the year.  However, as time passed, and these risks didn’t worsen in addition to the economic data holding up/improving – they became more noise than reality and investors were inclined to reposition for less dire outcomes. 

I will say this though, positioning and sentiment have experienced a 180-degree turn from last Fall to today.  At the October 2022 market lows, only 43% of respondents to the University of Michigan consumer sentiment poll believed there was upside to the S&P 500.  As of the July survey, that number hit 55.1%, where it was in February 2022 (when the bear phase was just getting started).  In the Conference Board survey, the share in June that was bullish jumped to 34.6% from 30.2%, and that is the highest since December 2021 (as the market was peaking). The Investors Intelligence poll is at 51.4% bulls and just 18.1% bears – that is extreme. The AAII also is at 41% bulls and 26% bears.  The NAIIM exposure index is up to 99.05 (at the same level it peaked at in November 2021 when the Nasdaq peaked) and up from 20 at the October 2022 equity market lows.  Yeah, investors are loaded back up on one side of the ship it seems; see Goldman Sachs “Sentiment and Positioning” indicator below.

There is nothing dire about pointing out the reversal in positioning this year from last year other than the reality that this positive rebalancing flow won’t act as a tailwind to higher asset prices going forward.  It won’t stop the rally from progressing, but it will take a little giddy-up out of the momentum.  Indeed, the equity (and credit) markets look very strong with the major averages right at 52-week highs, breadth robust, and leadership diverse.  But understand that this setup cuts both ways at this juncture.  Just as I’m inclined to ride the wave with our current portfolio exposures (and I have no interest in trying to be a hero by shorting equities), I’m equally inclined to not add much additional risk exposure in the face of historically elevated sentiment, rich valuations, and fully positioned bulls.  Especially when you can get a 5% risk-free return out of T-bills. 

To me this rally off the October lows still lacks what I would consider a sustainable improvement in fundamentals to validate it.  It has every bit the taste and smell of investors being wrongly positioned for worst case outcomes that didn’t materialize and then having to reposition accordingly.  With GDI negative for two consecutive quarters, real retail sales and industrial production at cycle lows, an inverted yield curve for going fifteen months, money supply contracting, loan growth rolling over, and corporate earnings set to contract for a second consecutive quarter - it's hard to assert that everything is hunky-dory.  No, this is a story of data besting a very low bar.  However, that only takes you so far and as it pertains to equities, it is my contention that they are now priced for very little margin of error if something goes astray in the quarters ahead. 

Unless this time is different (in some ways every time is a little different) and the Conference Board’s Leading Economic Index has completely lost its gusto as a forward-looking indicator, then there remains a legitimate level of risk on the horizon.  Last week we learned the LEI contracted for a 15th consecutive month and is down -7.8% year-over-year.  At no point in the last five decades has such a depth of decline been experienced in this metric and the U.S. skirted a recession.  For sure, this time could be different, but markets are acting as if it’s a virtual certainty that the U.S. doesn’t experience a ‘hard landing’ and that a ‘soft landing’ is secured.  History suggests that those carrying such a convicted view are betting against the probabilities.        

On the docket this week we have the Fed meeting on Wednesday, the second revision for Q2 GDP and ECB meeting on Thursday, and PCE on Friday.  This is also the biggest week of Q2 earnings season with 170 S&P 500 companies reporting (roughly 40% of the market cap) including Alphabet, Meta, Intel, P&G, Coca-Cola, McDonald’s and Ford.  As for the Fed, markets are 94% priced for a 25-basis point hike on Wednesday, and I don’t expect Powell and Co. to strike a dovish tone with the stock market 6% off its all-time highs, home prices appreciating, inflation (while falling) still above target, and the unemployment rate at 3.6%.  Not to mention the recent spike in food and energy prices which I’m sure is giving some Fed members anxiety over a potential reacceleration upwards in inflation readings in the months ahead.

Keep in mind the conditions at play going into this Fed meeting versus where they were when the Fed decided to take a pass at the June FOMC.  The S&P 500 is up nearly 5%, 10-year inflation breakevens have risen 15 basis points, and credit spreads have compressed in both the high yield and investment grade market.  In a nutshell, financial conditions are little changed since the June meeting and since the May 3rd meeting when they last hiked rates, financial conditions have eased by more than 100 basis points.  This runs counter to the Feds objective in tightening policy which then requires them to pushback even harder with their language in getting across their hawkish bias. 

Recall from the last Summary of Economic Projections (SEP) that of the 18 FOMC participants, only 6 have the Fed not implementing anymore rate hikes after this week’s meeting. The next meeting isn’t until September 20th with the Jackson Hole symposium taking place from August 24th to the 26th where the theme is ‘Structural Shifts in the Global Economy’.  Between the meeting on Wednesday and the September FOMC they will get two payroll and two CPI reports to work into their analysis of whether to sit tight and let the lags take shape or continue to tighten. Former Fed Chair Bernanke came out last week suggesting this should be the last hike of the cycle. 

While I am firmly in the Bernanke camp that this will be the last hike it must be acknowledged that the level of fiscal stimulus still working its way through the economy via the Inflation Reduction Act, remnants of the 2021 American Rescue Plan, and other planned budgetary spending could buoy the economy for several more quarters.  Former Dallas Fed President Kaplan was on CNBC this morning highlighting this very point.  Without a doubt the level of fiscal stimulus this cycle especially when compared to coming out of the GFC has made it ‘different this time’.  Merrill Lynch had a very informative chart in a research piece they published over the weekend quantifying the level of fiscal and monetary stimulus both during the pandemic and post-pandemic.  The U.S. and Western Europe (the two largest economic regions on the planet) injected more than 30% of GDP in fiscal stimulus from March 2020 – December 2021 and nearly 5% and 7% (respectively) of fiscal stimulus since January 2022.  That is a massive impulse into the economy.  

However, this deficit boosted spending comes with a cost.  We are starting to see the consequence of this increased debt load and the Fed hiking rates by over 500 basis points.  The 12-month sum of federal interest expense now exceeds the annual outlays from defense spending. 

And this number is only going to grow as the Treasury rolls over maturing lower yielding debt into higher yielding debt. 

A similar dynamic is at play when it comes to consumer pocketbooks where the U.S. consumer has spent 100% of its excess savings from the stimulus checks handed out back in March 2021 – this provided a big lift to the economic verve in the second half of 2021.  During the height of the pandemic uncertainty – call it February 2020 to November 2020 – consumers were acting with frugality in mind as households paid down their credit card balances to the tune of $128 billion.  However, since then households have increased their credit card balances by an unprecedented $282 billion to a record high of $1.25 trillion (see chart below from David Rosenberg).

This increased indebtedness is coming at the lofty price of record high 21% interest rates on the unpaid balance and we are starting to see the negative side effects take hold.  Delinquency rates are on the rise, and the probability of being rejected from a new card application just spiked to an all-time high.  This crutch for the consumer is reversing and is coinciding with the return of college loan payments restarting in October.  Not to mention prices at the pump have risen 10% since the start of summer – all our pocketbooks are set to get a little leaner.         

As for markets, commodities have made a resurgence over the past six weeks.  It wasn’t too long ago they were left for dead with A.I. and tech all the rage, but recent aggression in Ukraine has wheat prices up 7% this month, corn is up 8% in the last three weeks, egg prices have ripped +20% in the last month, natural gas is up 20% in the last three months (just in time for the extreme heat conditions), and WTI oil prices are flirting with $80/bbl after slumping into the mid-60’s in early May.  All in all, the CRB index is back to its highest level in six months.  Not what the Fed wants to see given all the progress made on the inflation file over the past twelve months. 

As for stocks, bonds, and the U.S. dollar I don’t have much of a convicted view on anything at the moment.  Bonds remain range bound as we move into the end of this tightening cycle.  I expect that yields will eventually move lower as the lagged impacts of this tightening cycle work their way through the system, but until the economic data turns down more decisively and recession risks resurface, I don’t see yields moving much one way or the other.   Same goes for the dollar.  We got weak flash PMI data out of Europe this morning and Germany is ensconced in recession, so it would seem the ECB is at the end of its tightening campaign as well.  That limits the upside in the Euro which perhaps puts a floor under the dollar.  The Chinese economy is weak and its likely they will roll out some form of a stimulus plan, but nothing actionable has been revealed yet.  So, with the other two largest economic regions in the world feeble or weakening its hard to see meaningful downside to the U.S. dollar. 

I put equities in a similar bucket.  They make me more nervous than excited with valuations on the S&P 500 pushing near a P/E of 20x, but there are also parts of the market that trade at much more reasonable levels.  For me the labor market remains the key catalyst for a pivot in all markets.  As long as it holds steady (even while weakening at the margin) then I think the prevailing trends will persist.  If/when the labor market makes a turn for the worse then I think the risk of things starting to unwind kicks into another gear, but until then sit back and resist the temptation to make a market timing call.  For me, a 1-year Treasury bill at 5.37% is a superior risk/reward investment relative to the S&P 500 trading near 4,600.  Note the ‘risk adjusted’ descriptor because equities could very well carry on their merry way as if there is nothing but clear skies ahead, but too many cautionary flags are waving in our work for us to get incrementally more aggressive with capital at this time. 

On a personal note, I will not be publishing a missive next week as I will be traveling to celebrate Mom and Dad’s 50th wedding anniversary.  Congrats to you two.  You’ve carved out a clear path for what it takes to make a relationship endure for 50 years.  Your relationship epitomizes the vows you’ve made to each other: “for better, for worse, for richer, for poorer, in sickness and in health, to love and to cherish, till death do us part”.  Thanks for being you and know that all your kids are grateful for the sacrifices you’ve made for us.  Can’t wait to enjoy the party.   

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