Markets have slipped in August as traders grapple with a resurgence in interest rates, weakening Chinese economy, and tepid earnings season. Through August 22, the S&P 500 Index and NASDAQ Composite have fallen just short of 4%, while the 10-year Treasury Note yield jumped from 3.96% to 4.36%.
PRICE Matrix Review & Outlook
The following is a broad review of the markets and economy through the prism of our PRICE Matrix (Policy, Risk, Inflation/Interest Rates, Credit, Earnings/Economy).
Policy
Monetary Policy remains tight, with the federal funds rate now up to 5.25-5.5%. At the July 26th meeting, FOMC participants “continued to see significant upside risks to inflation, which could require further tightening of monetary policy.” It is clear that the Federal Reserve, while keeping in mind the lagged effect of monetary policy, remains committed to bringing inflation down to, if not the storied 2% goal range, a lower and sustained level. Bond and futures markets have responded to the Fed’s hawkishness: since June 1st, the probability (calculated by the CME using the federal funds rate futures market) of a 550-575bp rate by end of year has exploded higher, from 1% to 38%. The impact has been felt across the yield curve, with long-dated Treasury yields rising to the highest level since 2008.
While Jerome Powell’s Federal Reserve gets most of the attention on Wall Street, it is evident that fiscal policy is an overwhelming contributor to the inflationary environment. The US budget deficit is up to $1.6 trillion through July. According to the Bipartisan Policy Center, revenues are down 10% year-over-year while outlays are up 11% over the same period. The $1 trillion infrastructure bill in 2021 and 2022 Inflation Reduction Act, historic mobilization of and increase in funds reserved for the military due to the Russia/Ukraine war, alongside catch-up investments in education, have all played a part in (1) the stock market’s strength, (2) the serious US inflation problem, and (3) low unemployment. This list illustrates the conflict policymakers face when they have the power to manufacture jobs and growth at the risk of a destabilized market system. Although not officially a policy stance, Democrats, in my estimation, have embraced the tenets of Modern Monetary Theory, which postures that countries issuing fiat currency (US, most others) need not worry about balancing expenditures with revenues. According to MMT, fresh money supply can make up for any imbalances. MMT is a controversial theory and has faced widespread criticism, and is therefore not fully and outwardly accepted by the left in Washington (as opposed to the zig to its zag, Trickle Down Economics). Nevertheless, it was thrown around frequently since 2021, especially during last year’s mid-term elections.
The rub to MMT, assuming it is a tacit player in the fiscal policy decision room, is in its stated solution to inflation, which is intended to rely on fiscal austerity. This is where the conversation comes full circle: while the onus has firmly rested on the Federal Reserve (monetary policy) to “fix the inflation problem,” the most effective stabilizer is of the fiscal variety. And as of yet, Washington has been decidedly averse to tightening the reins, most recently evidenced by a debt ceiling resolution with nearly effortless ease. As we head into year five of the COVID/Post-COVID era in 2024, it should be addressed whether policies best suited for multi-sigma recessions are prudent with 3.5% unemployment and a CPI 17% higher than in January 2020 (pre-COVID. For comparison, the CPI took eleven years to rise 17% from the August 2008 peak).
OUTLOOK: continued hawkishness from the Federal Reserve; continued profligacy from fiscal policymakers. The net effect is an inflation problem that persists into 2024.
Risk
The August selloff has brought the S&P 500 Index below its 50-day moving average, although it remains firmly entrenched above the 200dma. The Index nearly tested the 6/26 low of 4328 but has caught a bid back above 4440 as of this writing. Large-Cap Technology stocks, the bedrock of stock market optimism a la the Nifty 50 of the 1960s/1970s, continue to lead the rest of the market by a wide margin, although weakness in Apple stock has brought the ratio below the 50dma. The chart below illustrates the correlation between tech leadership and overall market strength, which has been generally the case since 2013 and has implications beyond its strong presence in the broad index.
Risk sentiment in terms of the CBOE Volatility Index (VIX) remains in a downward trend despite a short-term spike from 13 to 17 during the August swoon. The Put/Call Ratio spiked this month but is expected to settle back down in the absence of a market-moving event.
The S&P 500 dividend yield, at 1.54% in July, sits starkly below both the 10-year Treasury yield and Treasury bills (5.46% for 3-month bills). The opportunity cost for stocks over risk-free alternatives is substantial, yet the implied risk is latent for now during this cyclical bull market.
OUTLOOK: The stock market may not sufficiently reward investors for risks, which increases downside risk.
Inflation & Interest Rates
The inflation rate has come down consistently since June (+9.1% year over year) and is now at 3.2%. Prices continue to rise on a monthly basis, rising every month since August 2022 despite already elevated levels. Wage growth, a “sticky” inflation factor as it is less sensitive to short-term fluctuations, is at 5.6% yr/yr and has outpaced overall inflation for several months. This trend, and high wage growth in general, is important as it (1) raises the risk of a “wage-price spiral” in which wages and prices engage in a positive feedback loop, (2) resilient wage growth makes the Federal Reserve’s job as inflation-fighter more difficult as consumers have more money to spend on goods and services, and (3) if wage growth continues to outpace inflation, and corporations find it more difficult to increase prices/profits, the cycle could culminate in reduced hiring and job cuts. This last point is supported by the stickiness of wages, wherein companies find it notoriously difficult to adjust employee wages downward and must resort to layoffs in order to [eventually] hire at a lower wage level.
Interest rates have seen a resurgence since April, aligned with the narrative of a “soft landing” for the economy, rally in energy prices following a late 2022 correction, and persistently high employment & wages. The yield curve is deeply inverted - the most since 1981 - and has been since July (a milestone event amidst a longer-term narrowing trend that began in April 2021).
OUTLOOK: Inflation remains elevated into year-end, while interest rates continue to disrupt the real estate and financial sectors.
Credit
High yield spreads, the gap between the yields on [default] risk-free Treasuries and low-grade corporate bonds, have compressed since March and now sit at 393bps (3.93% above Treasuries of similar maturities). This level lies in the range of historical averages and signifies rather optimistic default rate expectations. Indeed, the US high yield default rate was a low 1.3% in 2022, up from 0.5% the year before. Looking ahead, Fitch Ratings expects the default rate to climb to 4.5-5.0% by year-end due to burdensome interest burdens. Data regarding US bankruptcy filings show that more companies have filed bankruptcies through July (402) than in all of 2022 and is at the highest run rate since 2020 (2010, excluding the 2020 outlier).
We define our credit analysis in terms of the (1) Cost and (2) Availability of debt market capital. While corporate spreads help identify the cost, data such as the Federal Reserve’s Senior Loan Officer Survey gauge the availability of credit. As seen in the chart below, the Fed’s rate hikes and brief banking crisis of earlier this year have driven banks to shore up capital and reduce lending (the survey asks approximately 100 banks about their lending practices). This tightening trend is also partly by design: the Federal Reserve offers interest on excess reserves to Reserve banks, in essence competing with the market for bank capital. By raising the attractiveness of keeping capital in the Reserve rather than conducting traditional lending transactions, the amount of capital accessible to businesses and consumers is reduced.
As seen in the chart, where recessions are shaded in grey, today’s levels of banking sector austerity are similar to those preceding and during recessions. Along with the deeply inverted yield curve (toss in violent moves in the secondary market bond), credit and interest rates are both living in interesting times.
OUTLOOK: Further tightening by financial institutions and regulatory measures in response to early 2023 bank collapses. Spreads could remain compressed through year-end but should climb sharply by mid-2024 on rising default risk.
Earnings/Economy
Q2 marked the largest year-over-year decline in earnings since Q3 2020, according to FactSet, although reporting companies largely beat consensus estimates by tempering expectations through Q1 guidance. Q3 is expected to bring a turnaround in both corporate EPS and US GDP. The Federal Reserve Bank of Atlanta is now forecasting a surge in Q3 GDP to 5.8% on a real basis.
The US real estate market is increasingly unstable yet benefiting from a lack of inventory. New home sales jumped higher to an annual rate of 714,000 units and have steadily climbed since the fall of last year. Prices for homes dropped nearly 10% in July on rising mortgage rates. The national average rate for 30-year mortgages is 7.09%, the highest rate since 2006.
At 3.5% currently and at about that level for over a year, the US labor market is exceedingly strong. Companies, as beneficiaries of government spending and consumer willingness to absorb not only wholesale price inflation but also purely profit-seeking price hikes, are in a position in which large-scale layoffs are few and far between. The exception to this was the substantial (and coordinated?) labor purge by tech companies at the end of last year, which has benefited those companies’ bottom lines.
Overall, the US economy has been riding a wave of instability and has yet to show definitive signs of cracking. However, instability as described throughout this review, raises risks that should be incorporated into a risk-managed, active portfolio.
One such risk lies overseas, as the Chinese economy struggles to rev up its domestic economy even after a full Post-COVID reopening late last year. Both Industrial Production (+3.7% yr/yr) and Retail Sales (+2.5% yr/yr) fell short of expectations. Meanwhile, the country has yet to resolve its real estate crisis, with two of its largest players, Country Garden and China Evergrande, facing large losses and, in Evergrande’s case, bankruptcy. Up to now, the stock market impact has been contained within its borders and to an extent its Asian neighbors. Given that China accounts for about 18% of the global GDP, with third place (US first at 25%) far behind (Japan, 4%), developments out of the region merit a watchful eye.
OUTLOOK: Strong Q3 GDP and earnings rebound, but is it priced in? Retailers are showing signs of consumer weighed down by rising non-discretionary costs. Overall, the US economy is surprisingly resilient to inflation and interest rates, though a review of fiscal policy points to an explanation.
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