After a pretty narrow stock market rally in May led mostly by the AI excitement which drove up technology stocks, the breadth definitely improved in June and brought a broader array of stocks higher. In the month of June, the S&P 500 was higher by 6.5%, the NASDAQ by 6.6% and the small cap Russell 2000 index by 8%
This all happened even though interest rates rose sharply in the month. While the Federal Reserve finally called a ‘time out’ on its rate hiking cycle in mid-June, the prospect of another one in July and maybe another one thereafter sent the 2 yr. yield up by 50 basis points in the month after rising by 40 basis points in May. At 4.90% as of this writing, it is just below where it stood right before the collapse of Silicon Valley Bank. As the 10 yr. yield was up a smaller 19 basis points in June after being up 22 basis points in May, the yield curve inverted further and now stands at more than a 100 basis point differential between the US 2 and 10 yr. yields. While not every yield curve inversion was historically followed by a recession, there hasn’t been a recession that was not preceded by an inversion post WWII. We will continue to watch this situation closely.
The European Central Bank and Bank of England (“BoE”) continued raising interest rates in June as the former has catch up to do relative to inflation and the latter is still dealing with very persistent UK inflation. The ECB hiked 25 basis points as fully expected by the market and said rates will likely rise by another 25 basis points in July. The BoE surprised the markets with a more aggressive 50 basis point rate increase, rather than 25 basis points, in response to an 8.7% inflation print seen days before for May and rates may go higher still. Yields also jumped sharply in Europe in reaction to this and the US rate rise. The 2 yr. UK gilt yield spiked by 55 basis points and its 10 yr. yield was higher by 46 basis points. Yields elsewhere in Europe were much higher too.
So, yields jump but stocks do too. What gives? There is not an easy answer, but we’ll try to figure it out. I do believe that while US interest rates are up sharply over the past few months, equity market investors don’t want to miss the ‘Fed is done hiking rates’ rally, believing that somehow that will be the ‘all clear’ signal. While historically the Fed has followed up within 6 months of rate hikes with eventual cuts in response to an economic recession, tighter monetary policy for longer is what the Fed seems to be committed to in order to contain inflation. There is also the belief on the part of investors that the US economy will either avoid a recession because we have not entered one yet or if we do eventually have one, it will be mild. While either scenario of course remains to be seen, it won’t be an easy job for the economy to smoothly absorb such a rapid rise in interest rates in such a short period of time and something that will continue to play out.
What a tighter for longer interest rate scenario brings is refinancing challenges for those that have debt coming due this year and next year. Because prior to 2022 interest rates were so low for about 15 years, loans coming due this year are being priced at an interest rate much higher than on the loan coming due. In most cases, current loan rates, either via the banks or the markets, are at least double the rates seen pre-2022. That is true for mortgage rates that of course impact households but also for businesses, particularly those in commercial real estate that are heavily reliant on borrowing. Rather than an event, this will be an ongoing process as long as rates stay high for a while.
With regards to economic growth, it’s been a mixed bag for the US and globally. Manufacturing, as measured by the ISM survey and the manufacturing PMI’s seen in the US and everywhere, is in contraction for 8 straight months in the US and 10 months in the global survey. We know consumers shifted their spending to goods from experiences during Covid and now have done a complete 180 where spending on leisure, travel, hospitality is where most of the attention now is. The housing market is the tale of two markets. The existing home market is seeing a dearth of inventory because of the sharp rise in interest rates that has the current 30 yr. mortgage rate at 7.17% as of this writing, according to Bankrate, which is more than double the 3% rate seen two years ago. Redfin estimates that 92% of existing mortgages have a rate below 6%, 82% have locked in a mortgage rate under 5% and 62% have one below 4%. Essentially these people are trapped in that it will take special circumstances for them to give this up. Thus, the pace of existing home transactions is near the lowest level since 2011 according to the National Association of Realtors. On the other hand, this is driving more demand for new homes where builders can fill in the supply vacuum to some extent and create buying incentives like rate buydowns and price cuts. The publicly traded homebuilding stocks have been stars this year in response to this.
Another factor that is flowing through economic activity is the post bank failure response from banks in terms of their lending behavior. Yes, the cost of capital is much higher, but lending standards have tightened as well and the demand for loans has softened. This will mostly affect small and medium-sized businesses who use the banks for their financing needs. Lastly, the US economy has and will continue to get a lift from a huge amount of government spending. There is still money going out to businesses via the Employee Retention Credit Covid Program. The US government is also subsidizing the building of semiconductor factories and a whole slew of green energy projects. The return on investment of this will be questionable but at least for now it’s leading to more economic activity.
The net result has Q2 GDP US estimates at between 1-2% after 2% growth in Q1 and 1% growth in 2022. Overseas the economic picture is also mixed. China’s economic reopening has been more muted than hoped for with manufacturing soft due to weakness seen globally in this sector and the shift away from goods spending. They are also digesting through the slowdown in their residential real estate market. The positive has been spending on leisure, travel and hospitality which has been robust post reopening. The Eurozone economy has seen a very slight contraction for two quarters of 0.1% through Q1 with little prospect of much of a Q2 rebound. This is in response to challenges in manufacturing and a slowdown in service spending because of the higher cost of living and rise in interest rates.
The positive with the global economy is inflation continues to moderate, albeit off high levels, as supply chain stresses have eased dramatically, and commodity prices have dropped. Due in part to base effects versus last year’s sharp rise in inflation and the moderation in goods prices and likely service prices, the US June consumer price index is expected to slow to 3% headline and a core rate of 5%. While that is still well above the sustainable trend of 2% the Fed wants to see, it’s headed in the right direction. That said, the question is where inflation will eventually settle out in 2024 and we believe it will be in the 3-4% range rather than the pre-Covid trend of 1-2%. This will help determine how flexible the Fed can be with rates and how long rates will stay high.
I believe the outlook for markets and the economy is clear as mud. We have a Fed that is most likely nearing the end of raising rates in this cycle. The fed funds futures market indicates that the Fed is committed to keeping rates higher for a while and still conducting quantitative tightening. We have an economy that is not yet in a recession but also not growing much and a recession is still a possibility. We have inflation slowing notably but prices are still up sharply over the past few years and are likely to remain persistent. We have had a robust start to the year in US stocks but now have earnings multiples of 20 times 2023 earnings expectations which has only been seen a few times over the past 50 years at the same time earnings growth is expected to be at best flat this year.
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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