Stocks finished lower last week as tech stock momentum faded. While there was some strength elsewhere, it wasn’t enough to offset the tech correction. Bond yields were essentially unchanged and there was little in the way of economic news that was market moving. The news over the weekend clearly focused on Russia and the attempted coup by Wagner Group leadership. With that said, markets move based on earnings and interest rates, not politics. Clearly, if the risks that the Putin government might fall were elevated there would be some stock market reaction. But it appears that is not the case. What happens to Wagner leadership and its members is still uncertain, but the status of Putin remaining in charge seems unquestioned, at least for now. So, with that assumption prevailing, markets will continue to look at earnings, future Fed decisions, market momentum and inflation.
Perhaps the most important news item this week will come from the Supreme Court. In particular, a decision is expected relative to the legality of Biden’s student loan forgiveness program. It is widely expected the Court will strike down this effort. But until we see the opinion, we won’t know Biden’s options. With the pandemic officially over, at least according to Washington, further deferment of payments is unlikely. Trying to find another way to forgive the loans, should the Court disallow the current attempt, is also unlikely. That suggests that if consensus holds and the Court strikes down loan forgiveness, payments will resume this fall and will almost certainly affect consumer spending. More than 10% of Americans carry some form of student loan debt. The incremental money they will have to spend has to come from somewhere, either savings or a diversion of spending toward debt service from discretionary spending. It is likely to hit spending on discretionary goods from new clothes to restaurant outings.
Let’s take a look ahead to Q4. Interest rates will be materially higher. That means the cost to carry an escalating amount of credit card debt will rise. Despite a break in energy costs, airline fares are at record levels. They could start to recede without impinging on airline profits given the sharp drop in jet fuel costs. A record number of new apartments will be coming online. That suggests either smaller increases in rents, or in some cases, declines. And then there is the impact of increasing student loan payments and higher interest rates in general. Economists, expecting a recession by now, have been frustrated by the ongoing strength in consumer spending, particularly for experiences, travel and dining. That strength has also supported employment growth in restaurants, hotels, and airlines. Put all this together and you get two conclusions. First, if the Supreme Court blocks Biden’s student loan forgiveness program, that will be an economic negative. Whether that is reflective in the stock market to date is subjective, but it probably hasn’t been fully reflected. Second, the impact of higher rates is a headwind that is still gaining strength. The odds of a recession by Christmas are increasing.
Excluding the top 7 stocks in the S&P 500, markets are only marginally higher year-to-date. I can’t tell you when the momentum for these top stocks will run out. Maybe last week was a hint. Maybe it was a head fake. But most of us don’t have portfolios comprised of 50% Nvidia# and 50% Apple#. These leaders aren’t going to continue rising at a 200% annualized rate no matter what AI adds to the equation. If the market is headed higher, participation has to broaden. As we approach earnings season and we listen to how sober managements are about the near-term future, we can adjust our conclusions. Given how well the economy has held up to date, I don’t expect second quarter earnings to offer any sort of major surprises. Corporate managements have proven adept so far at protecting profits in a sideways economy. Strengths have been in the obvious places from tech to travel. Weakness has been focused on some retail segments, commodities, and interest sensitive stocks. Right now, I don’t expect earnings to provide much to feed on for either the bulls or the bears.
As for the Fed, Chairman Powell now talks of the need for two more rate increases. Given his track record when it comes to prognostications, the only real take away is that an increase later in July is highly likely. Beyond that, more data is needed to come to any real conclusion one can write in ink. What no one knows, including Powell, is the lagged impact of prior rate increases. If there is to be a recession, it certainly will start quite a bit later than originally thought. That doesn’t mean we can conclude that it is going to be avoided. Optimists point to the apparent rebound in new home construction. Given that housing is viewed as a key leading indicator, that gets a lot of attention. But housing activity, as measured by the level of sales, is way off prior peaks. The lower appetite to buy is a given, a result of sharply higher mortgage rates. But what is unique to the housing picture is the lack of supply, also a consequence of higher rates. Trading a 3% mortgage for a 7% mortgage makes little sense. Thus, the buyers still willing to take a 7% mortgage (or who buy for cash) are turning to the new home market, given the lack of quality homes available at any price. That set up is unique to housing and shouldn’t be extrapolated to the rest of the economy.
We feel that the odds of a recession are still at least 50%. The severity will be closely linked to future central bank rate actions. There are signs of stress today. We have seen problems at regional and community banks. Credit card balances are back near peaks. While delinquencies are still contained, they are rising. Inventories are also rising. That is hurting the pace of manufacturing. Finally, the government continues to pile on new regulations increasing costs and lowering productivity. Except for the AI fervor and the fear of missing out, there would seem to be little impetus to push stock prices straight to new highs.
Today, Derek Jeter is 49. Chris O’Donnell is 53. Finally, with the Tour de France set to begin, former winner Greg LeMond turns 62.
James M. Meyer, CFA