Tug Of War Over Outcomes & Timing
Another week of choppy sideways price action in the equity market: Dow +0.12%, S&P 500 -0.16%, Nasdaq Composite -0.39%, and the Russell 2000 -0.24%. This was the second straight week of declines for the major averages (except the Dow) with the S&P 500 down in five of the last seven weeks. Sure, the S&P 500 is still up nearly 16% ytd, but that is largely on the back of the Magnificent Seven and multiple expansion (S&P 500 trading at a forward P/E of 19x from 17x at the turn of the year). The lethargic price action over the past month or so has the internals looking less constructive. Currently only 30% of the index is trading above their respective 50-day moving averages, which is exceptionally weak considering the S&P 500 is only ~3% away from its 52-week high. To me, it remains a ‘shoulder shrug’ market where it’s hard to get too negative and equally hard to get too confident – in particular when breadth is slipping to present levels.
Another data point that both bulls and bears can argue about is the flood of new cash into money market funds which is on track for a record $1.5 trillion by the end of this year. The bulls see this as dry powder sitting on the sidelines set to push equity prices higher if/when it flows into stocks. The bears argue that a 5% return with virtually no risk is enough of an allure to just park the money, sit back, and relax. Why take more risk than is prudent and/or necessary in the equity market when the earnings yield on the S&P 500 is 5.2% versus a 5.44% yield on a 12-month T-bill? Right here, right now I side with the bears on this point, those going whole hog in the stock market are not receiving any premium relative to the risk they are taking. I also think it’s a bit arrogant when equity cheerleaders just assume that cash on the sidelines is always earmarked for an eventual return to the equity market irrespective of the prevailing conditions. Sure, if stocks dropped 25-30%, valuation multiples compressed 3-handles to below historical averages, and yields came down 1-2% from 15-year highs – then investors with cash on the sidelines would very well have a compelling reason to reconsider their position. But in the absence of such a change in fundamentals I consider the trade-off between 5% risk-free and the 5% earnings yield as less compelling than the odds of one walking out of the casino with multiple stacks in hand– possible but the odds are not in your favor.
Don’t get me wrong, there are risks worth taking in stocks today, but in a measured and calculated fashion. Being 100% allocated to the S&P 500 given the fundamental setup and the option of a secure 5% alternative is not a position I would advise.
Markets and investors continue to be caught in tug-of-war between handicapping various outcomes and the timing of those outcomes – hence the sideways chop since mid-June. The outcomes everyone seems to have latched onto are:
Soft landing – both economic growth and inflation settle around trend levels (call it roughly 2% for each) without significant disruption to the labor market. Nick Timiraos penned a piece on this in today’s WSJ “Why a Soft Landing Could Prove Elusive” that is worth a read. For reference, in only 3 of the past 14 Fed tightening cycles has the Fed been able to engineer a soft landing. That’s roughly 20% odds, which I think is an accurate probability for such an outcome this time.
No landing – economic growth continues to run above trend, inflation continues to moderate but stays above the Fed’s 2% objective, and the labor market remains historically tight. This outcome is a rarity in the historical archives (1994 perhaps the only occasion) and as such investors should assign a similar probability – not 0%, but less than 10%.
Stagflation – economic growth slows, inflation remains sticky to the upside, and the labor market weakens. Also, a rare outcome for the U.S. economy when looking through the history books. Sure, it could happen for a quarter or two, but unlikely to persist for a prolonged period of time. However, I would peg the odds above the ‘No Landing’ scenario – closer to 1-in-4 or roughly 25%.
Hard Landing / Recession – economic growth contracts, inflation falls hard, and the labor market weakens considerably. This is the highest odds outcome in the history books following the conclusion of a Fed tightening cycle. Where this outcome gets misconstrued is over the timing of when it occurs, but the actual occurrence is greater than 50% odds.
What’s made the last eighteen months challenging for investors is that each of these outcomes has been priced at various times and to various degrees: in the Fall of 2022 markets were pricing in the recession outcome, then in early-2023 markets began to embrace the soft-landing outcome, which evolved into a no-landing outcome in late-July when the S&P 500 was threatening its all-time highs, and most recently with the rally in commodities markets / oil investors have moved incrementally towards stagflation. Complicating matters for investors are that each of these regimes rewards different factor exposures for investment success – there hasn’t been a one size fits all strategy for the last eighteen months. So, you’ve had to be flexible and willing to adjust in order to catch parts of these regime shifts. Big-cap tech got hammered in 2022 while energy and defensives did well. This year its energy and defensives that have performed the worst while Big-cap tech has been ripping. However, since June energy and commodities have been the outperformers while most of everything else has been lifeless to down.
All of that is a lot of mumbo jumbo to say a lot of nothing other than to describe what has happened after the fact. As for how I see things looking forward, our work has us leaning in the direction that a hard landing/recession is the next regime to be priced by markets. Time will be the ultimate arbitrator on whether this is the right view or not, but we don’t come to such an outlook by drawing straws. Rather we see an increasing number of headwinds over the next six months that either didn’t exist or weren’t as strong over the past six months. In particular, several pillars of the fiscal stimulus sweepstakes are set to moderate considerably or outright end as we move through the calendar into Q4 (paired down savings from previous fiscal handouts, student debt relief, and the Employee Retention Credit). Not to mention the lagged impacts from the peak in Fed rate hikes working their way through the system. Bank lending continues to tighten and demand for credit outside of credit cards continues to wane.
Then there are market prices signals indicative of a tightening in financial conditions coming down the pike. Interest rates across the curve are near or at cycle highs as markets have embraced the ‘higher for longer’ mantra Fed officials have been guiding towards. While credit markets have been mostly unaffected so far with spreads remaining tight, this general rise in rates does amount to an increase in the cost of capital. In the housing market the effects of a 7.7% thirty-year fixed mortgage rate (+160 basis points surge over the past year) have taken the median monthly mortgage payments to a record level of $2,632 (+14% more than this time last year).
Additionally, the DXY dollar index is threatening to breakout to the high side as it has rallied for nine consecutive weeks. Lastly, we have Brent oil prices pushing towards $95/bbl today after more than an +11% surge over the past three weeks (+30% since late-June).
The move in oil is working its way into pump prices with gasoline prices up more than 20% over the past three months (this is a $40 billion annualized hit to consumer pocketbooks). The boomers with all their retirement savings and locked in mortgages maybe better poised than most to weather this storm, but at the end of the day the median U.S. consumer is going to feel the pinch of this toxic cocktail.
As for the Fed, they have a meeting on Wednesday where markets are pricing in a less than 5% probability that they raise rates, and we are down to 31% odds of a rate hike coming in November. Just because it’s widely expected that the Fed skips a hike at this meeting doesn’t mean Chairmen Powell can’t deliver some fireworks with his messaging. The labor market is firm, and inflation prints over the next several months look like they will remain sticky to the upside (well above the Fed’s 2% objective) which provides plenty of coverage for Powell to continue to reinforce the “higher for longer” mentality. If he wants to stick with a hawkish bias then I would expect to see stocks, bonds, and even gold come under some selling pressure on Wednesday, and the dollar to breakout to the upside. Risk assets are not coming into the meeting with high expectations which makes it just as likely (more so perhaps on a shorter-term basis) that any hint of dovishness and a meaningful rally could ensue. We’ll just have to wait and see how it plays out, I don’t much care about the short-term setup.
Although, it is worth pointing out that if the bears are not able to push risk assets lower and bring about some real pain in the next couple weeks, it could setup a scenario where money managers have to chase into year end and risk assets catch quite a bid into what is seasonally the best part of the year.
Back to the Fed and why I think this hiking cycle is at its end (whether they put another 25 basis point on the board by the end of the year is irrelevant in the overall scheme of things) is because of comments like the one made at a conference last week by New York Fed President John Williams:
“…pointing to measures of inflation that incorporate a widely anticipated slowdown in housing-rent growth, which suggests underlying price pressures are near 2.5%...
I’m not saying the job is done or we’re at 2.5%, but it is showing us there’s some favorable, if you will, tailwinds bringing inflation down.”
If we truly are heading towards an underlying rate of inflation of around 2.5%, then a Fed funds rate of 5.25% - 5.50% implies a near +300 real policy rate (5.5% Fed funds rate minus 2.5% inflation rate equals 3.0% real rate) at a time when most estimates of the neutral real rate are closer to +50 basis points or even zero. This attests to the acute level of monetary policy restraint. Whereas, if the forward implied year-over-year inflation rate for the next 11 months is accurately being priced by the futures market (see chart below) for inflation to fall to 2.36% by next August then a Fed simply staying on hold (higher for longer) is continuing to tighten monetary policy by doing nothing.
Afterall, real rates at both the 10-year maturity and 5-year maturity (light blue lines in the chart below) are at their highest levels since just before the GFC in 2007. It’s hard to fathom an economy with nearly double the level of outstanding debt being able to handle a level of real interest rates that nearly blew up the financial system sixteen years ago. I’m not saying we have another GFC on our hands – lending standards are different, the debt profile is different, bank balance sheets are different – I’m just genuinely skeptical that everything goes smoothly notwithstanding a couple regional bank failures. Bottomline, we need more time to assess the success or failure of this tightening cycle.
Let me end with a final comment on Fed policy and bond market pricing because there has been a lot of repricing in the bond market over the last several months even though the Fed has only hiked the Fed funds rate 50 basis points in the last six months. Back in April the yield on the 10-year Treasury note was sitting at its lows for the year at 3.6% following the bankruptcy of three high-profile regional banks. The swaps curve back then had -100 basis points of Fed easing priced in for 2023 and another -100 basis points of cuts for 2024. A total of -200 basis points of Fed relief.
Not so fast, as it turned out, the central bank’s constant nattering of “higher for longer” has finally convinced the bond market that the Fed is serious and so today we have no rate cuts being discounted for this year and just -75 basis points of easing for 2024. So, 125 basis points of easing expectations have come out of the futures curve, and in the process, the 10-year T-note yield jumped 75 basis points to nearly 4.35%. If the Fed signals hard at this week’s FOMC meeting that it is not cutting rates at all in 2024, tracing out that impact on the 10-year yield, keeping in mind what is still priced in, would push it up an additional 40 basis points. That is assuming that the market ends up believing the Fed will keep rates where they are even as inflation falls – which would represent a further “passive” snugging in this already super-tight policy setting via ever-higher real interest rates.
So, while I do like Treasuries and think the timing is right for investors to start inching their way back into longer duration bonds, there is some risk for interest rates to move a little bit higher in the short-term. However, for investors with a time horizon that extends out into the second half of 2024 / early 2025 I think there is room for yields to come down considerable if the hard landing scenario plays out. I’m not beating the table with total conviction that such a scenario plays out, but I do think from a market pricing standpoint this is one of the areas with the most favorable risk / reward. The Fed could very well have to cut interest rates next year just to keep policy from getting more restrictive if/when inflation falls further.
Think about it, there is a chance that this Fed can pull off the historically elusive ‘soft landing’ (I have my doubts, but remain open minded to the possibility) – if you’re Jay Powell, isn’t it worth trying to pull off? Afterall, inflation is on the path to your objective, the stock market has held in well, housing remains firm, the labor market is solid, and you didn’t blow anything up in the process – what more could you ask for?
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