July brought the 5th straight month of gains in the S&P 500 and the 6th of the 7 months seen this year. The 3.1% rise was joined by a 4% rise in the NASDAQ and the 6.1% rally in the small cap Russell 2000. With that latter index, after its 8% jump in June, it reflects a more broadening out of the market rally which up until that point was very concentrated in the large mega cap technology stocks. US corporate credit also joined the rally in US stocks. International stocks were up too with the Euro STOXX 600 index higher by 2%, the Shanghai composite was up by 2.8% and while the Nikkei was flat in July, it follows a 23% rally in Nikkei for the first six months of the year.
This market action comes in the face of another sharp rise in interest rates and this time the longer end of the curve as the 2 yr. yield was up a notable 90 basis points combined in May and June. While the 10 yr. US yield ended July at 3.96%, as of this writing it stands at 4.08% after touching 4.18% and joins bond yields across the world that have moved higher. While the Federal Reserve did add another interest rate hike at the very beginning of July to a new range of 5.25%-5.50%, it was the widening of yield curve control by the Bank of Japan that stole the headlines and became a key influencer on global bond markets as many are highly correlated in the direction they move. I will discuss more on this below.
The other thing of note that took place in July was the almost 8% rise in the CRB index (benchmark commodity index) that took it to the highest level since last August. It was driven by a combination of a rally in oil prices as well as food prices. As for oil, a continued fall in the US rig count, Saudi Arabia and the rest of OPEC+ adherence to the agreed upon supply cuts, along with steadier global demand than initially thought were the main reasons. With respect to food prices, the Russian bombing of Ukrainian ports where they export a large amount of wheat and other crops, along with Putin’s threat of ending their grain shipment deal was the main worry. Separate from this situation, sugar touched a 10 yr. high in July and cocoa, for all those chocolate lovers including myself, hit an 11 yr. high. We cannot yet rest easy when it comes to the deceleration in overall inflation trends.
The US dollar index in July fell for the 4th month in the past 5 and in the 8th month in the past 10. This drop followed a ferocious 23% rally that began in June 2021 when Jay Powell at his FOMC press conference said the committee is finally talking about tapering QE. The rally ended in October 2022 just as the Fed was ending their very aggressive cadence of four 75 basis point rate hikes in a row. Thus, the direction of the dollar has mostly been in response to the Fed’s actions relative to other central banks. With the Fed close to ending its hikes (we’ve thought that for a while now however and they keep hiking), the dollar direction will be very important to watch here because of its influence on interest rates, inflation, US imports/exports, and investment flows.
All the year-to-date gains in the S&P 500 this year have been P/E multiple expansion as earnings expectations for 2023 are slightly lower from where they stood in January. I believe the main reason for this is the hope and wish that the Fed is almost done raising interest rates after the most aggressive tightening campaign in 40 years. Also helping is a natural rebound after the tough 2022 and the belief that the US economy will experience only a modest slowdown in response.
I think the analysis needs to span wider here as I believe that while the Fed has done most of their rate hikes in this cycle based on their own dot plots, they remain committed to not just having inflation fall but having it stay down. That means interest rates will stay higher for a while and the Fed will continue on with quantitative tightening. With the S&P 500 trading at 20x 2023 earnings and this new rate environment, I still expect choppy waters for stocks.
After pausing at its June meeting, the Fed’s late July meeting brought another 25-basis point rate hike as they fully telegraphed. They have certainly been very persistent with their tightening campaign after getting blindsided by their transitory inflation belief. As for the September meeting, the odds are low for another hike according to the fed funds futures and looking at this market through December the market is indicating about a 25% chance of one more hike. Thus, maybe for real this time the Fed is done hiking rates. What the Fed does however with the fed funds rate is only to manipulate the short term part of the yield curve. QE is where they tried to manipulate other parts of the yield curve. Outside though from QT, the longer maturity part of the yield curve is market driven and that is where we saw some fireworks in July that has carried over into August.
It’s important to understand that over the past 10+ years with the experience of zero rates, negative rates and QE globally, sovereign bond markets around the world have become much more correlated in their direction. It is also essential to be a student of history to understand the historical context. It was the Bank of Japan that created the recent experience with QE and non-existent rates (aka, zero rates), as well as the transformation of bonds from assets to liabilities through negative rates. The Bank of Japan has also been the last major central bank in the world to react with tighter monetary policy in the face of higher inflation.
It is also essential to be a student of history to understand the historical context. It was the Bank of Japan that authored the recent experience with QE and non-existent rates (aka, zero rates), as well as the transformation of bonds from assets to liabilities through negative rates.
That began to change ever so slightly when in December 2022 the BoJ tweaked its yield curve control whereas they allowed its 10 yr. JGB yield to hover either above or below zero by 25 basis points. In December 2022, they widened it to 50 basis points. Well to the surprise of many, they effectively widened it at the end of July 2023 to 1.00%. I say ‘effectively’ because it wasn’t an explicit target as they said they would tolerate a new range of .50-1.00% with possible interventions in between so a spike higher doesn’t happen all at once.
The reason why this is so important, on top of what was just stated, is for a few reasons. First, the Japanese is the largest foreign holder of US Treasuries and if JGB yields start to become more attractive relative to US ones, they could further sell down their US holdings, which they’ve been doing since last year. Also, many global traders have borrowed yen cheaply because of their very low rates and have leveraged that into other assets in a so called ‘carry trade.’ Higher Japanese rates could lead to an unwind of that. Lastly, if the BoJ now starts buying less Japanese bonds, and thus there is less QE, there will be less liquidity that they are pumping into the world. I believe this has been the main reason for the recent uptick in global bond yields, in Asia, in Europe and in the US. In a very leveraged world, we must pay attention.
US GDP in Q2 grew by a greater than expected 2.4% q/o/q annualized after a 2% increase in Q1 2023. In the face of much higher interest rates, this has been an impressive performance and why many have tempered their recession calls and the consensus seems to be that the Fed will be able to land this plane softly. I think it’s way too premature to make that call because of the ongoing impact that higher rates have on debt that comes due each and every day because the interest rate on the loans coming due is well below the rates now on offer. Those in commercial real estate in particular are feeling that first hand. Thus, I think the pernicious impact of higher rates for longer still has more time to play out. The internals of the economy are pretty mixed too. US manufacturing, along with manufacturing around the world, is in a recession as measured by the ISM and S&P Global PMI’s. New home construction is doing well but the pace of transactions of existing homes is near the lowest since 2011 according to the National Association of Realtors because of the dearth of inventory. The high end consumer keeps spending, particularly on travel and leisure but the lower to middle income consumer is still digesting years of falling real wages. In the upcoming years, government actions will wield a significant impact on economic activity, though the outcomes of these endeavors on investment returns remain uncertain. Through initiatives such as the infrastructure bill, the Chips Act, and the poorly named Inflation Reduction Act, the government created billions of dollars of subsidies, tax incentives, and straight spending. These resources are poised to support various sectors including infrastructure development, the building of semiconductor plants, and ventures related to renewable energy, including the construction of numerous battery plants.
It is not easy to balance all of these moving parts and come to some coherent summary since there is so much going on and sometimes themes conflict and don’t make sense. That is the investment business however and the life we’ve chosen. While the US economy is not in a recession, one ahead is still very possible. We have the positive of falling inflation but a rate environment that I do not believe goes back to its pre Covid trend of 1-2% sustainably for a while. We have had a robust start to the year for stocks but valuations are now again in nosebleed territory.
Whatever comes our way though in this very tricky investing landscape, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor.
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