As of market close July 7, 2023. Returns in percent.

Investment Insights

 — Steve Orr 

Halftime 

Today we will step back and look at the big picture. Around the globe, economies continue to struggle with inflation, higher interest rates and slow growth. The U.S. is a bit ahead of the pack in all three areas. Over the last three years the U.S. led the world in money creation (some $15 trillion), resulting inflation at 9%+, and zero to 2% growth. Over the last two quarters, inflation has fallen by half and our GDP growth has held near 2%. 

Inflation will stay above the Fed’s goal of 2% for some years to come. Our economic growth over the last several years has been fueled by deficit spending by Congress. The Congressional Budget Office projects deficit spending to exceed tax revenues by $1.4 trillion this year, roughly the same amount as 2022. 

After a very interesting first half of the year, let’s take stock (pun) of the markets. In the first half of 2022, the S&P 500 took a 21% Bear beating. The Fed started a new interest rate increase cycle that March and began selling off its bond portfolio. This year’s first half was a climb, stumble and climb for the S&P 500. After a 9% run into February, and the failure of several banks in March, stocks gave back most of those gains. Encouraging first quarter earnings helped the major indices reclaim February’s gains in April and finally break higher in early June. At quarter end the S&P 500 sat just 6% below its all-time high. Despite its impressive rally this year, the tech-led NASDAQ is still 11% below its November 2021 high. 

This time last year we pointed out there were seven cases since World War II where the S&P 500 had dropped 20% or more. In each of those cases the index rallied at least 20% over the ensuing year. At quarter end the index stood 17.5% higher than a year ago. Not quite the 20%+, but in the face of rising interest rates and sticky inflation, it’s a nice win. Digging into the postwar period, the eyeshades at Bespoke Research tell us that in those 78 years the S&P 500 has risen over 10% in the first half of the year 22 times. In those 22 years the average gain was 7.7% versus a gain in other years of only 3.1%. 

Through early June the rally was all mega-cap driven. Thirty names in the S&P account for more than 95% of the index’s gain this year. The magnificent seven — which are the seven largest in the index — account for roughly three-quarters of the index’s gain. Only three stocks generated 45% of the S&P 500’s 16.8% return in the first half of this year: Apple, 18%; Microsoft, 14%; and Nvidia contributed 13%. Nvidia, of course, was the lead dog of the Artificial Intelligence mania, posting a total return of 189% for the first six months. 

June’s price action saw Mid- and Small-cap stocks finally take the lead over the mega-caps. Both of the smaller sized groups beat their large-cap brethren by over 1%. Even with an 8% month, however, their relative strength remains in the neutral zone. The NASDAQ, S&P 500 and Dow Industrials all finished the quarter in overbought territory and their charts suggest slowing momentum. More on that in a moment. 

Momentum?

The Federal Open Market Committee skipped a rate increase for the first time in this cycle last month. The Committee raised its overnight interest rate range ten times over the last six quarters from zero to one quarter of a percent to the current 5% to 5.25%. The higher rates momentum should pick back up this month. We expect two more increases this year before an election year pause. We think short-term rates will average just over 5.50% by the end of this year. 

Interest rates traveled the same path as stocks in the first half of this year. Rates followed the Fed higher, peaking in February. The banking deposit failures of Silicon Valley Bank and others sent traders scrambling into U.S. Treasurys. This flight-to-quality trade pushed bond prices temporarily higher and rates lower. Late last quarter government borrowing restarted, and the drain from bank deposits slowed. Traders unwound bets that the banking crisis would cause the Fed to pause or even stop raising rates. Inflation and job numbers evidenced enough economic strength that traders prepared for more rate increases from the Fed. Bonds went on sale and rates began to climb again. 

Today the two-year Treasury sits at 4.94%, close to its 5.07% high in March which was its highest level since mid-2007. Further out the curve, at 4.06%, ten-year Treasurys are also approaching their high of last October, when they closed at 4.22%.  Ten-year levels are important because many home mortgages are priced off of its yield level. 

What is the destination for rates? Just like the Fed, higher for longer. A terminal overnight level of 5.50% for Fed Funds over the next year should lift two-year rates north of 5% and a flattening yield curve would see tens reach 4.5%. 

The path to get to higher rates will not be straight, thanks to changing views on how far the Fed will raise rates, not if they will. The Fed is determined to bring down inflation. To drive the economy into a recession is not a mistake, in their view. The mistake is not getting inflation down. Unfortunately, the only tools at the Fed’s disposal are higher short rates and selling off bonds out of its balance sheet. Those monetary policy tools are fighting the fiscal policy of Congress’s deficit spending. 

Spending more money than you have is a form of leverage. Creating dollars and pushing them into markets and the economy stimulates more activity than otherwise would have occurred. Whether that activity generates enough economic benefit to actually pay back the U.S. Treasury debt issued to raise the deficit money is a question we only contemplate in the wee hours. Can Congress slow down on the deficit spending and lower the pressure on prices? They do not have a promising track record. 

Tool effect

Back to monetary policy — that interest rate tool. Experience tells us raising rates takes a year to filter through the economy. Okay, we are now at least sixteen months on from the first increase. Housing has gone through a tough recession and started to rise. Industrial production continues to drift lower. Employment seems to be doing just fine, thank you. Over 200,000 new jobs per month will easily absorb new cohorts of graduates around the country. Jobless claims have risen slightly off their lows but are nowhere near recession levels. 

What should keep the Fed up at night are this year’s labor contracts. Dockworkers on the west coast got record raises. Railroad and airline pilot wages are in play. UPS and the Teamsters remain far apart and a strike is on the horizon. The Teamsters represent 340,000 UPS workers, and a strike would be the largest walkout since the 1950s. The link between higher pay and higher spending leading to higher prices is fairly strong in the economic textbooks. Rents, food and car prices are proving to be sticky in many areas of the country. The only good news on the inflation front is that U.S. oil production continues to hover around 12.5 million barrels per day. That along with moderate demand has helped the headline inflation numbers come down. Interest rates can actually make workers raise demands for wages — higher interest rates require more cashflow to pay off debts of any kind. 

Defying

Our economy continues to roll along in second gear — not too fast but the engine is straining a bit. Services, construction and oil production are the bright spots, relatively speaking. Industrial production remains recessionary. Coming into 2023, we assigned a very high probability to a recession in the second half of the year. GDP growth has averaged 2.3% over the last two quarters, defying the recessionary slowdown we envisioned. This is suspiciously different than Gross Domestic Income, which is running at a -2.6% rate. The two series are rarely identical, but it is very rare for them to be more than a half of a percent apart. Something tells us GDP is going to get revised lower in the coming months. We dislike being part of the herd, but find ourselves with company in thinking that a mild recession, if we have one, will be late this year and into the first quarter of 2024. 

China merits our attention because it may already be in recession. In their terms, GDP growth of around 3% is a recession. They are running about 4% growth right now, if official statistics are correct. Youth unemployment is at a record 20.8%, meaning many college graduates are having a tough time finding work. Real estate problems, bad loans from local governments and very slow reopening are holding down the growth rebound. The strain shows up in the offshore Yuan, which has fallen 8% this year against the dollar. Our indicators have kept us out of emerging markets as China is still some 30% of the index. We have no view on when China will get a handle on its debt and employment problems.