The equity market started off last week with four consecutive days of losses. Investors digested the latest Fed rate hike (Wednesday), ho-hum earnings from Apple (Thursday), and a solid jobs report (Friday) to which the net conclusion with last Friday’s strong rally was a S&P 500 that was for the most part violently unchanged – 4,169 coming into the week and closing the week at 4,136.  The broad indices remain wedded to a range that is frustrating even to the most committed bulls and bears.  No matter how emphatically anyone wants to argue their investment case the reality remains that the S&P 500 is unchanged over the past three months and the past twelve months.  Now, a lot has happened with the progression of this business cycle during that time but the recent narrowing of market leadership limits areas to get excited about and renders reliable buying opportunities scarce.   

In my estimation last week’s Fed meeting was a bit of yawner in that the Fed hiked rates another 25 basis points to a range of 5.0% - 5.25% and committed to letting incoming data guide it going forward.  Powell’s post-meeting press conference was little more than nearly an hour-long word salad of “this” and “that” with a heavy dose of committing to nothing.  A lot like my commentaries of late.  The truth of the matter and this pertains to last week’s job report as well – the aftermath of the pandemic both in terms of societal changes and the policy reaction has injected a significant amount of noise into the data.  Through both fiscal and monetary measures policymakers injected nearly $10 trillion of stimulus into the system.  They are now in the process of attempting to siphon some of that out of the system and the level of restriction needed to accomplish this is proving to be more than most expected fifteen months ago when monetary tightening kicked off. 

However, it’s important for investors to be cognizant of the lags not just from monetary tightening (rate hikes and QT), but also the fiscal side.  In the next few months, the market will have to contend with debt ceiling shenanigans - not just observing how the “sausage is made”, but also the liquidity impacts of the finished product.  Once the debt ceiling is raised or punted down the road via a continuing resolution the Treasury will come to market with a heavy dose of bond issuance to rebuild the TGA balance.  This will represent a significant reduction in liquidity.  Additionally, two fiscal policy stimulus measures enacted during the pandemic will be expiring – employment retention credits and student loan forbearance.  This will add to the strain on some households’ pocketbooks and comes soon after the March 1st expiration of extra Supplemental Nutrition Assistance Program (SNAP) in 32 states (affecting 32 million people).   I don’t think it’s a coincidence that these program phaseouts are aligning with the rise we’re seeing in outstanding credit card balances.  The percentage of U.S. adults with more credit card debt than savings has risen from 21% in 2021 to 36% in 2023.   

As for the debt ceiling, Treasury Secretary Yellen has been hinting that the government could begin having trouble paying its bills as early as the beginning of June.  The drop dead date remains a fluid situation depending on the timing of incoming receipts and outgoing expenditures.  If the Treasury can make it to June 15th (a large tax receipt influx expected) then it’s likely the debt ceiling showdown could be extended out as far as late July.  Nevertheless, this boogey man in the closet is lurking.  The fact that the Fed is tightening policy into such a fiasco and with a yield curve inverted now for nearly a year just elevates the risks.  Memories of the summer of 2011 should be top of mind for investors.  The U.S. didn’t default and ultimately the debt ceiling got lifted, but markets experienced a meaningful degree of pain during the process:

• The VIX tripled from roughly 15 in June to 48 in August

• The yield on the 10-year Treasury fell by more than 100 basis points

• Gold spiked by more than 25%

• The S&P 500 corrected by more than 15%

Keep this in mind as a reference point.  Nothing says it must play out identically this time, but executing some restraint and keeping some powder dry should a similar opportunity present itself seems prudent. 

This week will be chalk full of the latest inflation reports (CPI, PPI, and Import/Export prices) and no doubt the talking heads will make these prints out to be the super bowl of data points, but our work continues to suggest to us that inflation is yesterday’s news.  This is a signal being screamed loud and clear from the commodities market:

• CRB Index is down -15% from last June’s cycle peak and at the same level it fetched in 2014, 2011, and 2010.

• WTI oil prices are off nearly -45% from its March 2022 peak.  At roughly $73/barrel, oil last traded here in late-Summer 2021, prior to that in late-Summer 2018, early-Winter 2014, the Fall of 2011, and before that the Summer of 2010. 

• Metals prices are down some 25% from their peak

• Lumber prices are down more than 70% and back to pre-Covid levels. 

Look, I’m going to keep it short and sweet this week as best I can describe it, capital markets remain in wait and see mode.  And that’s just what I think investors should be doing – let the cycle, cycle – wait, watch, and react accordingly.  At no point in the past fifteen years have investors been so generously compensated with nearly 5% money market rates or 4-5% short-term Treasuries for executing patience.  Compare 5% risk-free to a 5% earnings yield on the S&P 500, high yield spreads at 460 basis points, or investment grade spreads at 146 basis points over Treasuries.  All of the latter carry a higher level of risk for not much more of an expected upside return from current valuation levels.  Let me spell it out clearly, cash is not a bad alternative at the moment.  A moment where the yield curve is inverted (a precursor to a recession), money supply is contracting, political leadership at all levels is lacking, equity valuations are on expensive side with a forward P/E multiple of 18x, and a VIX index hanging around 17. 

My overall view remains flexible and/or agnostic while leaning in the direction of the bears.  The forward-looking data continues to point towards an oncoming economic recession – the depths and duration of such an event can’t be known at this time.  However, I’ll admit the economy and corporate earnings while decelerating and contracting, respectively, have proven to be much more resilient than expected by those sharing a similar view to mine.  I do think the lagged impact of monetary tightening is starting to bite with a little more vigor of late; especially considering the challenges popping up in the regional banks.  In my estimation small caps are painting a more accurate picture of the ongoing downturn as their EPS are already down 13% from the peak vs less than 5% for the S&P 500.  The seven mega cap Tech companies pulling up the S&P 500 this year (AAPL, MSFT, GOOG, AMZN, TSLA, META, NVDA), all great companies, but at 30x times forward earnings they are priced for stellar execution.  See the below chart from BofA Merrill Lynch showing the relative price performance of U.S. Tech vs. the S&P 500 – all-time highs (don’t forget all time is a long time). 

Apple was a great illustration of this with their report last week where they got the benefit of the doubt because of their strong balance sheet, wide economic moat, impressive profit margins, and great execution, but revenues contracted on a year-over-year basis for the second consecutive quarter (they’re guidance included another quarterly decline in revenue is coming).  Do they deserve to be trading at 29x forward earnings?  For now, the market thinks so, but compare them to the remaining 493 companies trading at 16x and you can see the disconnect.  Small caps in my estimation are already pricing in 60 – 70% odds of an economic recession.

I’ll end with this, it’s unlikely the market moves towards pricing in anymore recession risk than it already has until we get the first negative payroll print.  At that point, if/when it happens then I think this range bound market breaks down decisively to the downside.  The upward rise in jobless claims, fall in overtime hours, decline in temporary staffing, and slide in Job Openings are all pointing in the direction of future labor market weakness.  We’ll see.  If/when this leg of the cycle starts to unfold, it’s our view that this will create a once in a decade opportunity to acquire “hard landing” assets such as commodities, small caps, emerging markets, and energy. 

Be patient as you’re not missing anything other than perhaps what the year-to-date scoreboard watchers are calling attention to, showing Nvidia up +99%, but still down -16% from its November 2021 peak.  Meta up +94% ytd, but still down -39% from its September 2021 peak.  Tesla up +39% ytd, but still down -59% from its November 2021 peak.  Microsoft up +28% ytd, but still down -12% from its November 2021 peak.  Apple up +33% ytd, but still down -6% from its January 2022 peak.  Amazon up +26% ytd, but still down -44% from its November 2021 peak, or Alphabet up +22% ytd, but still down -28% from its February 2022 peak.  Yeah, a lot of commentators forget to mention how all these companies are recovering from the hammering they took over the past seventeen months.     

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