Asset classes across the spectrum are kicking off the holiday shortened week in ho-hum fashion following the news over the weekend that a tentative debt ceiling agreement has been reached.  The deal still must get through the House and Senate, but early indications are that it strikes enough of a bipartisan balance to get across the finish line (fiscal restraint but not enough to crush the economy – two years of spending caps instead of the ten the GOP was looking for).

As for the equity market, it’s become a momentum-based performance chase on the back of a handful of mega-cap Tech companies.  I know this sounds like a broken record, but the divide between the Russell 1000 (+9.3) and Russell 2000 (+0.4%) so far this year is the widest gap in 26 years.  Another way of illustrating the same story is by looking at the performance of the S&P 500 (blue line in below chart) since the start of February (+3.2%) versus the equal-weight S&P 500 down -7.1% (orange line) – chart compliments of Liz Ann Sonders.

Putting aside one’s opinion for the moment and just focusing on what is transpiring, what we are witnessing is a growing trend of market concentration, where a small group of the largest stocks are becoming more and more responsible for the returns in the stock market.  Add to the recipe a catchy, yet legitimate, narrative like AI and you have the makings of passive flows and discretionary managers chasing performance, causing a massive surge in market capitalization for a narrow chunk of the equity market.  While the ytd performance of the S&P 500 gives the illusion of a strong equity market, in reality we’re seeing an increase in market fragility, as the absence of a safety net within the index can have disastrous results.       

Consider the following data from Ned Davis Research tracking the % of total stock market capitalization of the top 5 stocks in the S&P 500:

• 2023: 24.1% (30+ year high)

• 2022: 19.2%

• 021: 24.2%

• 2020: 17.8%

• 2015: 10.5%

• 2010: 11.6%

• 2005: 14.4%

• 2000: 20.1%

This level of concentration is pushing some relative performance metrics within the equity market to historical extremes.  For instance, the current performance difference between the Nasdaq 100 and the small cap Russell 2000 index is at its most extreme level in history, only rivaled by the peak of the Technology Bubble in 1999 (chart compliments of Richard Bernstein Advisors).  Does this mean that things unravel in the same way as they did back in 2000 where Technology stocks cratered versus small cap stocks from 1999 into late-2002?  No.  No one knows how this iteration of market history plays out, but it does provide all investors with useful context to consider in their investment decision making.    

What is becoming more obvious to this market observer with each passing day is that market internals are indicative of the recession trade being put on across an expanding list of asset classes.  Let’s start with the U.S. dollar which has rallied for three consecutive weeks and at 104.4 is eyeing its 200-day trendline at 105.7.  This renewed dollar strength is coming at a time when both Chinese and European economic data has been demonstrably weakening.  And its not as if U.S. economic data has been on fire (more on this below), which implies the strong dollar is being primarily driven by a risk-off flow of capital.

Then there are commodities, which move inversely to the price movement of the U.S. dollar.  Commodities have been getting absolutely smoked as of late.  Below is an abridged list of price changes from their respective peaks:

• Natural Gas -81%

• Lumber -73%

• Nickel -57%

• Wheat -55%

• Cotton -51%

• Aluminum -43%

• WTI Oil -45%

• Copper -29%

• Corn -26%

• Steel -26%

• Soybeans -21%

Perhaps someone needs to bring this to the attention of the Fed members who continue to focus on the inflation story while looking through the rearview mirror.  Yeah, let’s continue to hike interest rates over and above the 500 basis points we’ve already hiked knowing full well we have a library of research published by our own Fed staff detailing the ‘long and variable’ lags from monetary policy adjustments.  The PPI index is sitting at +2.3% y/y versus the CPI index at +4.9%, but no one cares.  It was the PPI index that signaled the coming spike in CPI back in 2021, but then, like now, this signal is being ignored.  At +2.3%, the PPI inflation rate is below where it was in late-2018 when Powell stopped that tightening cycle. A year ago, PPI was +11.2% year-over-year and today it is 890 basis points lower – an unprecedented decline over such a time span. 

Inflation in the real economy, i.e.) hard assets and commodities are spiraling lower.  The only thing not yet in retreat is greedflation at the hands of corporate America infatuated with protecting margins, but my hunch is somethings going to give on this front.  Either volumes will continue to fall as most durable goods manufacturers and retailers are seeing as consumers push back on additional price hikes or price competition kicks off with companies seeking market share gains at the expense of margins.     

Which brings me to the U.S. economy where after last weeks revised Q1 GDP report has me wondering whether we are already in a recession and we don’t yet know it, as was the case in March 2001 and December 2007.  Despite the modest upward revision to first-quarter GDP, when you add the components of the economy that are the true “economic guts” (consumer spending, housing, investment, and non-residential construction) real GDP expanded at less than a 0.5% annual rate in Q1.  Below is the trend in year-over-year growth of GDP over the past six quarters:

• Q4 2021 +7.5%

• Q1 2022 +6.2%

• Q2 2022 +3.3%

• Q3 2022 +2.1%

• Q4 2022 +0.5%

• Q1 2023 +0.0%

There has not been an occurrence in the post-WWII era where the trend in domestic non-government GDP completely flatlined on a four-quarter trailing basis and the economy not gone into a NBER-defined recession.  Beyond that, we saw within the report that real Gross Domestic Income (GDI) contracted at a -2.3% annual rate in Q1.  This followed a -3.3% retreat in Q4 of last year.  Never in the post-WWII era have we had such back-to-back declines and the economy not been in a NBER-defined recession.  What I find fascinating is how everyone was dismissing the back-to-back negative GDP prints as recessionary at the start of last year and pointed to ‘GDI being positive’ as the reason why such a view should be faded.  But here we are with the shoe on the other foot and so few are giving it the respect it deserves.  When you average out both real GDP and GDI, this metric came in at a -0.5% annual rate in Q1 on top of -0.4% in Q4 2022.  This average has contracted in four of the past five quarters.  Jason Furman, former CEA head under Obama and highly respected economist, put out the following tweet thread following the GDP release in which I think he properly frames the backdrop:

Another interesting data point that came to light in the GDP report was that National Account Corporate Profits fell -5.1% quarter-over-quarter in Q1.  This was the worst showing since Q2 2020 and marked the third consecutive contraction in economy-wide profits.  The year-over-year trend has reversed violently from +10.9% a year ago to -2.8% currently.  One thing that is important to distinguish in both the economic growth and profits data is the difference between rate of change and levels.  Yes, both growth and profits on an economic basis are in fact rolling over and outright contracting, but both are doing so from an elevated post-mother-of-all-time-high stimulus injections.  For instance, while Economic profits are contracting, they are only back to where they were in Q2 2021, which at the time was an all-time high level. 

I will say, this data does fundamentally tie in the price performance of most of the equity market over the past twenty-four months.  Economic profits have been flat over the past two years, which is in line with an S&P 500 that closed at 4,202 on June 1st, 2021 and is trading at 4,204 as I type.  Other areas of the equity market are more aggressively priced for a deeper recession like the S&P 600 small cap index which is more economically sensitive.  It is in month 19 of its bear market and still down more than 23% from its cycle peak.  This is a deeper drawdown than what it experienced during the 2001 – 2002 recession.  Even when one pulls back the onion on the S&P 500 what you see is an index where 8 of the 11 sectors are down on the year.  Cyclical and interest rate sensitive sectors fairing the worst – Energy -11.5%, Utilities -8.5%, Financials -6.6% and Materials -2.7%.  Even some defensive sectors are struggling with Healthcare -6.7%, Real Estate -2.9%, and Consumer Staples -2.6%.  It’s a Tech and AI driven world at the moment and it will stay that way until it doesn’t. 

However, don’t think for a second that the stock market is nearly as strong as the S&P 500 suggests.  We’re in this unique window where nearly 25% of the index is comprised of just five companies that are being propelled more by capital flows, passive indexing, and performance chasing than anything fundamental.  At the same time investors have concluded that food is no longer important as companies in the agriculture space get hammered: Deere -18% ytd and the largest fertilizer company in the world Nutrien is down 26% ytd and -52% since last August.  Or that the clean energy transition initiative being propagated by leaders from around the world will no longer require natural resources to achieve success with copper miners like Freeport McMoran -10% ytd and down -27% since the end of January.  Or rare earth miners like Mountain Pass which has a monopoly in the Western Hemisphere on key battery metals being down 13% ytd and down -46% from early March.  Then you have high quality energy companies in the oil and gas space like Chevron -15% ytd and -19% since late January, Schlumberger -17% ytd and 26% since mid-January or Texas Pacific Land Corp -45% ytd. 

What I’m getting at is that the market is starting to present opportunities outside the handful of mega-cap Tech stocks for investors willing to consider a time horizon that extends beyond one’s nose.  If the economy weakens further from here it’s most likely many of these companies’ share prices will decline further, but the true opportunity in my mind exists in one’s time horizon.  Looking out two, three, and four years these cyclical businesses will be in a much different earnings profile and accelerating into a secular expansion.  Yes, it would be nice to be able to time it perfectly and pick the exact bottom for an entry point on many of these names, but succeeding repeatedly in this fashion is an unrealistic expectation.  The alternative is to build out a position over time as prices come into levels that make fundamental sense over the course of a business cycle not just at what looks like to be the trough of some of these industry business cycles. 

Rubbing salt in the wound of some of these beaten-up sectors is a large rebalance in some sizable momentum-based ETF’s over the last several weeks.  One of the largest ones is the nearly $9 billion iShares Momentum Factor ETF (MTUM) detailed below by analysts at Wells Fargo. Where the ETF is increasing its weighting in the Technology sector to nearly 21% from less than 3% and decreasing its weighting in Energy and Healthcare by 19% and 17% respectively.  This helps explain some of the sizable relative weakness in these sectors starting last Friday and adding fuel to the fire in the Tech sector.   

Bottomline – equity market price action (narrow leadership in a handful of crowded mega-cap tech names), cyclicals under pressure, small caps at cycle lows, commodities getting wacked, inflation rolling over aggressively, and the feeble GDP prints over the past five quarters all support the argument that we may already be in a recession.  On a positive note, should we see stock market price action broaden out into other areas with the laggards starting to catch up to the tech leaders on a relative basis – one might be inclined to believe that the equity market has already priced in the recession and that an economic recovery awaits as early as Q4 or Q1 of 2024.

Let me sign off with some random thoughts on the upcoming end of the student loan moratorium and debt ceiling aftershocks.  Between the end of June and September 30th those individuals carrying student loans will have to start making payments on their outstanding balances for the first time in almost three years.  This is a big deal because young people tend to spend most, if not all, of their incomes.  A New York Fed study estimates that student loan borrowers saw $195 billion worth of payments waived in the first two years of the moratorium, which means this amount has likely swelled to around $300 billion.  Additionally, President Biden’s $400 billion student-loan forgiveness program is up for decision from the Supreme Court in late June with strong indications that this program will be shot down.  We’re talking about 40 million borrowers with a payment stream totaling roughly $5 billion per month which will no longer be saved or spent into the economy, but rather redirected to student loan repayments.  According to an analysis from Jeffries, this is equivalent to 0.6% of aggregate personal income which suggests a meaningful rollover in consumer spending is on the horizon for later this Summer. 

As for the debt ceiling, while the focus has been on the ‘IF’ of a debt deal, I continue to be most concerned about the liquidity drain that is likely to emerge following its passage as the Federal government shifts from unfunded spending to sterilized spending.  Secretary Yellen is expected to issue roughly $750 billion in T-bills and notes over the ensuing two quarters to rebuild the TGA while at the same time the Fed will continue with its balance sheet reduction via QT.  This is going to act as a meaningful drag on liquidity and place pressure on risk markets that haven’t existed for most of 2023 due in large part to the TGA drawdown and introduction of the BTFP following the regional banking crisis in March (two items that were adding liquidity). 

As for the Treasury market, it has been trading very poorly on a technical basis, and with the 10-year T-note yield having broken above all its major averages, the charts do indeed point to a retest of the 4% level. It has to be stated emphatically that 4% has acted as a major source of support for the past fifteen years, including the three times this occurred since last fall.  And guess what? Over a 1- to 3-month span, the total return has been positive 100% of the time (as in, 8 for 8) and by an average of +7.5% (and median of +6%).

While some ascribe the move up in Treasury yields to a more hawkish Fed and a firmer economy, the actual reason is that fixed income portfolio managers had been busy making room for the flurry of corporate debt issuance that has taken hold of late in advance of any possible disruptions from any violation of the debt-ceiling limit (sharply pulling forward their financings).  Investment grade companies have come to the market with a huge $112 billion of new bond issues so far in May — about triple the $46 billion floated in May 2022 (and more than triple the amount sold in April).  Excluding 2020, when ultra-low interest rates and the Fed’s rapid QE reacceleration triggered a $196 billion borrowing spree, corporate issuance this month is the highest for any May since 2016.  Back then, the 10-year T-note yield popped up +15 basis points in the second half of the month and then went on to slide 35 basis points in June.

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