Pressures Building
Short note this week as I don't have much new to share and see even fewer things to do. Equity markets were flat last week, while the signal-to-noise ratio has become quite skewed (more noise, less signal). The abundance of unactionable news (as it pertains to markets) isn't all that surprising as we head into the summer months and global election cycles take center stage. Don't get me wrong, I'm not implying political outcomes are not important, but 95% of the daily talking points should be relegated to the dustbin, given how useless they are for investment purposes. Sure, we've seen some market impacts following last week's Presidential debate and the significant shift in odds in favor of the former President and away from the current President, but nothing overly dramatic at this point.
What I find myself most focused on right now is tracking the pace at which the U.S. economy is slowing and the intensifying pressure from tightening financial conditions. No, we're not at pull-your-hair-out levels, but we are encroaching on nail-biting territory. I say that because growth covers up all kinds of fragilities, but when growth slows, the risk of those fragilities metastasizing increases rapidly. Incoming data for the last several months has taken a discernable step down: labor market, housing activity, manufacturing activity, retail sales, and inflation.
Unfortunately, this Fed remains firmly focused on inflation, which looks to be back on its downward trajectory but is still too elevated above the Fed's target to pivot back to a dovish bias. This combination of slowing growth (but not too slow) and falling inflation (but not low enough) is the worst kind of macro goldilocks environment for asset prices. At the same time, growth isn't slow enough to elicit Fed cuts, which ignite animal spirits, and it's not strong enough to meet optimistic earnings expectations embedded into an S&P 500 trading at a forward P/E of 21x. Furthermore, the combination of slowing but elevated inflation delays the start of an easing cycle, which is necessary for bonds to overcome the headwind of massive Treasury issuance due to runaway fiscal deficits.
As a result, we're seeing oil, interest rates, and the U.S. dollar move in a direction that causes financial conditions to become tighter, reminiscent of the playbook that played out in 2022. In 2022, virtually all financial assets declined in value, and we had a mini relapse of this experience in the fall of 2023 when oil prices rose, yields hit their highs for the cycle, the U.S. dollar flirted with its cycle highs, and the S&P 500 made its low for the year.
Oil prices peaked on September 27th, 2023 at a little over $96/bbl.
The U.S. dollar index peaked on October 3rd, 2023 at 107.
The yield on the 10-year T-note peaked on October 19th, 2023 at 4.99%.
And the S&P 500 bottomed on October 27th, 2023 at 4,103.
The peak in all of those variables from the end of September until late October and continued weakness into the start of 2024 acted as a significant tailwind for the subsequent rally in U.S. equities. However, all of these variables are meaningfully higher today compared to where they were at the start of the year, and all are moving higher in tandem since the beginning of June. This is why we've seen such a narrowing in breadth within equities in the past month as more and more capital concentrates in the monopolistic mega-cap Tech companies that are better insulated from these marginal cost increases. The chart below from Kevin Muir does a great job of encapsulating the rise in the S&P 500 (top chart – blue line) over the past 20 months, occurring in tandem with a recovery in forward 12-month earnings per share (middle chart – yellow line), but the kicker is that P/E valuations (bottom chart – green line) have risen to its highest level since before the pandemic. In short, earnings have increased with price, but price has risen faster than earnings – hence, valuations have become more expensive.
The bottom line is that I find myself back in the 'indifferent' camp when it comes to capital markets at this moment. Directionally, stocks could continue to drift higher with the S&P 500 perhaps flirting with 6,000 by year-end, but the path from here to there is likely to be choppier than the first half of this year. Bonds are even less enticing to me than equities, with the exception of short-duration high-quality instruments (investment grade credit and T-bills). I continue to like Gold, but I think it continues to consolidate while perhaps even slipping to as low as $2,200/oz before resuming its bull market. Frankly, it's been a good start to the year, and given all the uncertainty that lurks out there over the next four months, I'll be content if we just chop around while maintaining current levels until then.
Before anyone reading this gets overly excited or nervous about my near-term caution, let me state plainly a structural view from which I'm viewing things today. The U.S. economy and financial system are operating with large and deeply embedded structural debts/deficits emblematic of what you see from emerging market economies. The lack of leadership and political dysfunction exasperate the situation. The solutions to resolve or improve these dynamics are painful: growth (least painful but most unlikely), austerity, and/or a prolonged period of above-trend inflation (inflate our way out of it). Let's face it: austerity is out of the question. There is just no appetite for it in the populist era we live in, and it's highly improbable that an economy as large and mature as the U.S. will generate the level of growth necessary to reduce debt levels to where they need to be. As a result, my expectation is that policymakers continue to take us down the path of inflating our way out for as long as they are able to get away with it. Such a scenario is not negative for stocks and tangible assets. These assets will experience heightened volatility in such an environment and, at times, make for an uncomfortable ride. But this backdrop is terrible for bonds and government debt (duration in particular). Keep that in mind when thinking about capital markets, and I also advise thinking about investing through both a cyclical and structural timeframe.
We'll get a slew of data this week that will be useful and timely in measuring the health of the economy. Starting with this mornings ISM manufacturing report which came in at 48.5 versus 48.7 in May and below consensus estimates for a print of 49.1. Tomorrow we get JOLTS data, ADP and jobless claims on Wednesday, and the BLS jobs report on Friday (consensus is at +195k versus 272k last month).
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