Investment Insights

 — Steve Orr 

Turn the corner.

In the nine weeks since mid-June, the S&P 500 has recorded only three down weeks. A very nice overbought, stretched rally by any measure. Bears have sat in the corner and moped for much of the bull run. Last week they had a few negative items to chew on. Treasury yields hit their highest levels since November after ADP’s Employment Report and the Treasury’s revised funding plans hit the tape. Apple slid 4.8% on Friday after reporting its third straight quarter of declining sales. Bulls liked Caterpillar’s results, the lower job report and manufacturing data. 

Disappointing results from Apple, Microchip, ResMed and CSX helped wipe out an early 1% gain in the big index on Friday. Those big names pulled the S&P 500 below mid- and small-cap names for the week. What pushed the week’s returns into the red for all of the U.S. markets was Wednesday’s downgrade of U.S. Treasury debt by Fitch Ratings. The news did not ruffle markets much at first blush, but stocks remembered S&P’s downgrade 12 years ago and headed south. 

Down the ramp

The last month’s economic data has offered up a number of pleasant surprises. Wall Street shops JPMorgan and Bank of America threw in the towel on their recession call. They did hedge themselves by saying the risk of a downturn is still very elevated. We agree that the risk of a downturn is high. We cannot, however, run the odds of a recession to zero. Post-shutdown, manufacturers scrambled to make and ship product to consumers and markets. Once the initial demand was satisfied, inventories began to build. That in turn led to fewer orders. The ISM New Orders index peaked in June 2021 and manufacturing output has been on the skids since. 

If there is less need to make stuff, then inventories get drawn down. So far, so good. What if orders do not rebound? Shippers, who ramped up to meet demand, take the first hit. Maersk, responsible for about one-sixth of ocean shipping, announced last week that the inventory correction “appears to be prolonged and is now expected to last through year end.” Troubled Yellow Freight appears headed to bankruptcy, in part because of falling volumes. We would note, however, that the New Orders index has appeared to be bottoming for the last two months. 

Consumer spending has carried the economy the last several quarters as manufacturing output stalled. Travel and dining out especially benefited. This summer anecdotal reports suggest consumers are changing their priorities. Delta and United reported good results thanks to international business travel. Southwest and JetBlue’s reports were, well, blue, due to fewer vacationers flying domestic. That equates to reports of lower attendance this summer at Disney and Six Flags. Disney reports earnings and attendance this Wednesday. 

In the typical ramp to recession — ah, slowdown — housing rolls over first (Feb 2022) and presages a recession in about 20 months. Manufacturing new orders peaked in June of 2022 about 12 months ahead. Corporate profits, weakening now, lead about three to six months. Employment is the last to slow — well, into a recession. Per Mark Twain, if history rhymes, then we should expect slower growth for the next several quarters. 

Slowdown

And about last Friday’s job report. A quick review: every job report this year has been revised lower in subsequent months. July’s estimated job gains were an “okay” 187,000 but were the second in a row to miss estimates. On the surface, that level easily absorbs new entrants to our workforce. Under the hood, however, the BLS’s small business birth/death model created 280,000 new jobs. The last two months, 60% of job gains were in government and education. Sorry, those two sectors rarely add to GDP growth. We wonder if job growth is finally slowing. If so, there should be some uptick in the coming weeks in jobless claims.

Downgrade

If there is irony in the world, it's markets versus reality. Just as Morgan and B of A say no recession, here comes Fitch with a downgrade of U.S. Treasury debt from AAA to AA+. Fitch has put our federal debt on negative watch before, but this is the first time the agency has followed through with the downgrade. Reuters provided us with a handy tracking table:

Standard & Poor’s took the plunge during the Boehner / Obama era, cutting the Treasury’s credit rating one step on August 5, 2011. The S&P 500 fell 6.7% that day. Nearly 12 years to the day, last Wednesday Fitch followed suit. Note that they were not the first: Egan-Jones dropped the federal debt one step to AA+ in July of 2011. S&P’s cut set off a double-digit drop in stocks and pushed Treasury yields lower by a quarter of a point. Treasurys were still perceived as a safe haven in light of the ongoing Euro meltdown. At the time, S&P was concerned about Congress’s rising spending and that our debt had reached 65% of GDP. 

Flash forward, Fitch is complaining about runaway spending by Congress and now federal debt that totals 98% of GDP. Congress spent $6.8 trillion in FY 2021, amounting to nearly 31% of GDP. In FY2022, spending dipped to $6.3 trillion in FY2022, or 25% of GDP. As this fiscal year comes to a close, the deficit is running near $1.4 trillion. The misnamed Inflation Reduction Act passed by Congress this time last year creates $891 billion in new debt and spending. The Administration is carefully doling out contracts and programs over the coming months to try and counteract a coming slowdown in the economy. The new borrowing has pushed Treasury bill and note refunding to record levels. The $102 billion in refunding this quarter of 3-, 10-, and 30-year paper will cost us taxpayers plenty. The maturing bonds’ interest rate averages around 2.25%, but the new paper will incur interest costs nearly double that. 

One difference from 2011 is now that two agencies rate Treasurys AA+, a number of municipal bonds backed or escrowed by Treasurys may be downgraded. The current budget deal will likely be “negotiated” in the media and back rooms in the last two weeks of September. Prepare yourselves for government shutdown threats. Again. We expect another “kick the can” deal into 2024 before the Presidential primary season.

Number 9

No, not a Beatles reference. Our trusty Stock Trader’s Almanac says preelection year S&P 500 performance ranks ninth out of the 12 months of the year. July is usually the best performing month of the third quarter. September ranks last across all indices and calendars in performance. The first seven months of this year, the S&P 500 rose just over 20%. That was the best start in 26 years. The rebound from 2022’s Bear cycle is all the more impressive given central banks around the world are raising rates and trying to pull liquidity out of the banking system in their fight against inflation. Since World War II there have been 23 cases where the S&P 500 has risen at least 15% in the first seven months. The next five months’ gains were not as strong. In three cases, notably 1929, returns were negative. The other 20 saw gains averaging around 5%. Hey, we would take a 24% to 25% year when the Fed is raising rates possibly another 1.25%, kinetic and Cold Wars are in full swing and interest rates are bottoming from a thirty-year Bull cycle.