Investment Insights

 — Steve Orr 

Down to Normal

August’s first three weeks remind us of two market memories. First, this is August, and a 5% correction is fairly normal. August averages at least three 1% or greater down days and we have already had two. Since 1952, about 10% of all August trading days have dropped 1% or more. Second, bonds and stocks both falling in price bring back vivid images of 2022. Granted, conditions are markedly different than a year ago. 

Rewind your memory tapes to last summer. Recession was just around the corner, the Fed was going to stop raising rates at 3.25%, Russia was mired in the Ukraine, and the Jets were going to win eight games. Today, recession is just around the corner — okay this winter, the Fed is going to stop after one more increase to 5.5%, Russia is playing defense in eastern Ukraine, and the Jets have Aaron Rogers. Perhaps things are not so different. 

This year’s stock rally helped the S&P 500 recover about three-quarters of its drop from the all-time high of 4,796 on January 3, 2022. The current rally’s high reached 4,586 at the end of July. Since then, the index has slid -4.8% through last Friday. The tech-heavy NASDAQ has taken the largest hit, falling -7.5% from its mid-July high. Three weeks of lower prices have taken most indices near or into oversold territory, so do not be surprised by a bounce in the next couple of weeks. The recent slide does not diminish our “neutral but cautious” stance toward stocks. Seasonal and technical indicators tell us to hold steady for now. 

Up, not down

The fundamental picture is a bit different. More than 90% of the S&P 500 have reported second quarter earnings through last Friday. 79% of index members beat their earnings estimates, about average for most quarters. Compared to 2022’s second quarter, earnings were about 6% lower in this year’s quarter. Consensus projections are for the third quarter to be near flat and fourth quarter to show near 8% growth. In the face of repeated forecasts of “soft landings” and recessions, 8% earnings growth looks pretty Bullish to us. 

July’s economic numbers also do not fit the slowdown theme. Nearly every leading indicator box for a recession has been checked, yet retail sales and charge card activity show consumers are out there braving the heat to spend. Target and Walmart gave upbeat assessments of activity and revenues, while hedging themselves that the outlook for the rest of the year is “uncertain.” Walmart executives cited September’s restart of student loan payments as a future drag on consumer spending. 

With those positives in mind, we are not yet in the “no landing” or even “soft landing” camp. For starters, we do not know what a “soft” landing is. A drift lower in GDP to 0.5%? Perhaps unemployment only rising 1% to 4.5%? The world waits for an answer. Market-based indicators such as the Conference Board’s Leading Index and the inverted Treasury yield curve are signaling that the Fed has raised rates too far and eventually those higher interest rates will impact economic activity. We would add rising energy prices, falling savings and tighter lending standards from banks to the mix. Slower growth remains our forecast for the winter into next spring. We would be happy to upgrade that outlook. 

One “up” brick in the Wall of Worry for markets is our national debt. Our national debt is now greater than the country’s annual GDP, and borrowing by Congress for spending is not slowing down. The Treasury unexpectedly raised its borrowing to $1 trillion this quarter and our federal deficit is on track to reach $1.7 trillion. Treasury Secretary Yellen wants to build the Treasury’s General Account back to $500 billion, which will require around $200 billion in new debt. China and Japan have been selling Treasury bonds to defend their currencies. The Fed also is adding to supply by letting its bond holdings mature. Additional supply usually lowers price, and our 10-year Treasury has responded by rising nearly 1% in yield to 4.25%, shaving about six points off the price over the last several months. 

At 4.25%, our 10-year Treasury Note presents a challenge to investors: Do I earn interest near the inflation rate for 10 years or buy stocks that pay less than 2% and expect more growth in earnings? Rates around the globe are pushing higher, thanks to post-shutdown spending sprees that have ignited inflation. In the U.K., inflation is still running above 7%, Japan at 3.2%. Both are triple the last 20 years’ average. Our inflation measures will likely settle at a new “floor” of 3%.  

Looking ahead at fuel and home prices, the next several months should show CPI rising toward 4%. Persistent inflation will pressure the Fed to raise rates at least one more time. Wall Street consensus thinks the Fed is either (1) done with increases [no], (2) will raise rates once more and then cut next spring, or (3) will start cutting in early 2024. History tells us that most, if not all, of the Fed rate cuts only came after rising unemployment and Fed “panic.” 

A bubble or other situation washes ashore, the Fed panics and jumps to lower rates. We always have to leave the door open for that possibility. For now, the Fed remains a committed inflation fighter. That view was reinforced after the release of the Fed’s July FOMC meeting minutes. Members were impressed with economic growth in the spring and early summer and worried that it would keep inflation above their 2% target. That is a valid worry. Chairman Powell speaks this coming Friday at the Kansas City Fed’s Jackson Hole Symposium. We expect his remarks will remain hawkish, tilted toward higher rates to fight inflation.

Down to where?

By far the largest and most unknowable WoW brick is that of China’s economy. First, a refresher: Some 40 years ago the Communist Party bet that becoming the world’s factory using low-cost labor from the countryside and having no pollution controls could quickly build a prosperous middle class and make China a player in the world economy. That bet paid off in spades. 

Now aging demographics, bad loans, real estate problems and reshoring trends are working against that economic model. China’s aspirations to dominate Asia and secure sea lanes for its oil imports have not helped relations. Re-read that last sentence. We wonder if that sentence were written in 1940 about Japan. 

Trends always work until they don’t, and China’s real estate bubble is a great example. Real estate represents about a third of China’s economy. Start with raw land. Local governments, like our counties, control the land. They fund their operations by selling land to developers. They, in turn, sell apartment and condo concepts to consumers, who put down deposits that can reach to 100% of the purchase price. Then after selling the concept, they build the building. An apartment is usually the largest asset owned by a family. 

China’s multi-year virus shutdown stalled projects and has sent a number of developers into bankruptcy. Now, two of the largest developers appear headed to bankruptcy. Evergrande filed Chapter 15 bankruptcy over its unpaid U.S. dollar bonds last week. Once China’s top-selling developer, Evergrande has liabilities in excess of $300 billion. Country Garden, the largest developer in China, missed interest and principal payments this month and reportedly owes over $200 billion in unpaid bills. By some estimates it has promised to build over 900,000 apartments in dozens of cities. If it cannot pay suppliers and subcontractors, then those apartments will not be built. We wonder what recourse those depositors will have against Country Garden. 

From what we can gather via English sources, the combined effects of buyer caution, tighter lending standards and higher interest rates, this appears to be China’s “Lehman moment.” Shades of 2008 when central banks and the Federal Reserve juiced our financial system with lower interest rates and emergency lending facilities. The Party ordered the People’s Bank of China to cut interbank lending rates last week, but it appears more drastic action will be needed. It is not difficult to imagine China slowing down to 2% to 3% growth over the next year from the forecasted 4.5% to 5%. China’s stock market makes up about 30% of the Emerging Market’s index. We remain out of Emerging Markets and would have to see a turn in the dollar and China’s growth trajectory push our indicators back to positive before taking action. 

Back again

Getting August over with brings a couple of positives: lower temperatures and football. One negative: Congress comes back from summer recess. It is an open secret in D.C. that House Speaker McCarthy does not have the votes for a full budget. Thus, we will be treated to the threat of government shutdown in October and breathless commentators bloviating on cable news. The likely result will be some eleventh-hour continuing resolution to fund the government until perhaps March. Remember that a shutdown just means non-essential workers are furloughed and the bills pile up until Congress directs the Treasury to start issuing debt after a budget deal is signed by the President. All government workers get paid after the government is turned back on. Have you ever wondered how things continue on normally when the “non-essential” workers are at home?