Stocks faltered for the second consecutive session after an extended streak of gains that, at least for the NASDAQ, has been the longest since 2019. Tech has been dominant. The NASDAQ is up 30% year-to-date while the S&P 500, also tech-heavy, is up 14%. An equal weighted S&P, however, is up just 4%. Long term bond yields have stayed within a narrow range for the past month while short rates have crept up, reflecting a belief that the Fed will increase rates again in July after a June pause. Futures markets predict that will be the last increase for this cycle. Note, however, that rate predictions beyond 4-6 weeks are notoriously inaccurate. The yield curve is more inverted than it has been in a very long time, an indication that the bond market still expects a recession. The stock market still expects a soft landing. Bull markets simply don’t begin just in front of a recession.
How do we square that circle? One can argue that subsectors of our economy have been going through a recession already. Housing weakened noticeably from the time the Fed started to hike rates in March 2022 through this past winter. However, demand for new homes has picked up noticeably in recent months despite high mortgage rates due to the dearth of new homes for sale. Who is willing to sell a home supported by a 2.5% mortgage to move to a new home carrying a 7% mortgage? Retail sales, especially for discretionary items like clothing, have been sloppy for months as consumers defer buying new goods to pursue experiences. Commodity sectors have suffered from weakening prices, from lumber to chicken to oil. Manufacturing has slumped as demand softened and inventories accumulated.
On the other hand, there are robust pockets of strength. Travel and leisure spending continues to boom with no letup. Housing activity, as noted, is on the upswing, at least as pertains to new home construction. AI is reaccelerating activity in technology. Restaurants, hotels and construction employ lots of workers. While the labor market isn’t as frenzied as it was months ago, the economy is still adding jobs at a pace far faster than many thought possible.
Against this backdrop, the Fed continues to tighten. While it has paused increasing interest rates, at least for now, it is continuing to reduce the money supply. Money supply is now contracting on a year-over-year basis at the fastest pace since the early 1930s. The Fed hasn’t even hinted when the process of reducing the size of its balance sheet will stop or even slow down.
Thus, if higher rates and tighter money haven’t slowed the economy yet, why will it happen? Are the stock market bulls right that there won’t be a recession? Can inflation fall toward 2% while adding hundreds of thousands of new jobs every month?
There is always a time lag between policy implementation and the impact of such steps on both inflation and economic growth. Data is also confused by the impacts related to Covid. Some industries boomed in 2020-21 during the pandemic while others atrophied. Then in 2022 extending into 2023, the opposite happened. I just returned from my first vacation overseas in four years. Auto sales are higher than a year ago in large part because new car dealer lots were empty last year. Businesses that benefited from Covid testing or working from home suffered in 2022 and so far this year. Sales of PCs and gas grills are way down for obvious reasons. You don’t buy a new one every year.
With all that said, there are signs that the economy is continuing to slow. The three-month average employment growth rate is slowly decreasing. Americans are eating into savings to support their urges to travel or go to Taylor Swift concerts. Restaurants are holding the line on pricing. Rents are falling. So are gasoline prices. As long as job security is strong, spending should support continued growth. The Supreme Court has yet to weigh in on President Biden’s wish to forgive a good chunk of student debt. But most expect his pledge will be declared unconstitutional. Over 40 million Americans carry some student debt. They have had to make no payments for almost 3 years. Biden can’t use the pandemic as a reason for deferred payments any longer. I won’t predict what might happen (I’ll leave political guesswork to others), but if debt payments resume this fall, that will be a weight on discretionary spending.
Whether we face a mild recession or a soft landing, the differences will be subtle. A flat economy means parts are growing and parts are not. It probably limits hiring, but layoffs might be mild unless any recession is deeper than anticipated. Right now, markets and the Fed are aligned that whenever the rate increases end, the likelihood of any rate cuts this year is small. Inflation won’t get back to the Fed’s 2% target before 2024 at the earliest. There is absolutely no reason rates should fall to the point that the real cost is negative anytime soon. If inflation stays near 3% for some time, a Fed Funds rate higher than that is likely for some time.
When money has a real cost, it reduces stupid investments. We don’t need more apartments, office buildings or shopping centers financed with free money. Better to spend the money on infrastructure and investments that can boost productivity. Stocks aren’t cheap. Even assuming flat earnings, stocks are selling over 19 times earnings. But P/Es can remain elevated if earnings hold up, and key sectors, like technology and healthcare can create new opportunities. For the past two months, stocks have risen at an unsustainable pace. Second quarter earnings season is just a few weeks away. I don’t expect major surprises overall. Flat results are a general expectation. But looking ahead, there will be some concerns. Congress will be under a lot of pressure to rein in spending. Given the ongoing growth in entitlements and a consensus to keep supporting defense, Federal discretionary spending will have to take a hit. If both sides can’t agree by September 30, some form of sequester is likely. As mentioned earlier, the student loan issue will also come to a head this fall. Even if Biden can find a way to cushion the impact, he can’t simply ignore the courts and defer payments indefinitely. Sell in May and go away wasn’t a good posture to take this year. But it is reasonable to expect some pause over the next few months. Rather than chase this rally, it probably makes more sense to build a shopping list for a 5% decline. Markets are never a one-way street. When everyone is bullish, it’s time to be cautious. Right now, volatility, as measured by the VIX index, is the lowest it has been since 2019. A good part of the recent rally was due to a combination of short-covering and hedge funds reversing their negative positioning. That may be coming to an end. Keep a sober focus on valuations. Pick your favorites and average in on any corrections.
Today, Scottie Scheffler is 27. Chris Pratt is 44. Gretchen Carlson turns 57.
James M. Meyer, CFA 610-260-2220