Markets are hard.
For the past two years now, the S & P 500 has made little progress and remains about 20% off its all-time peak made in late 2021. While investors continue to debate interest policy, it always seems to be this week’s data point, or next week’s data point, that will always be “the next” most important ever data point that will reveal the path forward and whether or not a recession is actually happening. The dilemma for investors now after watching and waiting with bated breath for two years now, is seeing most results come to the same conclusion.
Equity markets have remained in a very narrow trading range and it appear as something has just “broke” with the US regional banks…and perhaps…the credit markets overall. The focus lately has turned to the commercial real estate market and CRE loans. The rate hikes have succeeded in causing a huge credit contraction already. The leading economic indicators, along with the bond market, are signaling a broadening economic slowdown, although the depth and duration remain to be seen.
It's easy to be confused. The fourth quarter data points, retail sales, industrial production, and other data, suggested the economy was hitting a wall. Then in January, nonfarm payrolls, retail sales, and manufacturing production……all surged. Huh? Maybe the unusually mild weather for January had an impact, maybe because of Covid, the global shutdowns, and the fiscal and monetary policy responses, the “normal” seasonal patterns of economic activity have been distorted even more? IKn which case the numbers may have adjustments in the future?
The latest inflation data and interest rate policy will continue to dictate the overall direction of financial markets. While inflation has seemed to be steadily receding since its peak last June, prices are still growing well above the central bank targets of 2%. The US jobs market remains remarkably resilient, riding a 53-year low unemployment rate of 3.4%. If this persists, expect interest rates to remain restrictive for longer, but once the central banks abandon the inflation flight (likely too early), expect inflation to remain higher for longer.
If the pessimistic narrative is wrong, and the US isn’t headed for a hard landing (i.e. recession), maybe it is headed for a “soft” landing, which would mean prolonged, but low, economic growth. Perhaps its possible we see a “no-landing” scenario where the US economy re-accelerates from here and does A-OK? The problem with the latter scenario is that inflation remains a major problem. Combine that with the economic equivalent of morphine wearing off as the high from free government cheques and loose monetary policy become a thing of the past, and there you have it….
Add to this an extremely dysfunctional political environment where politicians on all sides aren’t concerned about the country but instead winning elections at any cost (i.e. “we can fix it later” type thinking), and this increases the risk of policy errors an unintended consequences exponentially.
This is why inflation will most likely remain persistent, and will keep coming and going in waves, similar to the early 1980’s when I started in finance. Here is the rub though:
THE FED CANNOT FIX THIS PROBLEM
Their ZIRP policies for almost a decade (zero-interest rate policy) short circuited the natural market’s reaction to the fiscal recklessness we’ve witnessed in so many asset classes which the Fed (and global central banks as well) has enabled. And worse:
There isn’t anyone standing up for fiscal rectitude anymore.
The connection between the taxpayer and the national debts has come completely untethered….so the governments will just run the tabs until the bond markets fully crowd out private investment (for starters). This may suggest by logic, that we could experience a window (“no-landing”?) where the economy is screaming higher, and the Fed (and other central banks) fall even farther behind the curve. Then inflation related trades should work well.
The main bottom line for us is that the bond yield curve remains deeply inverted, which has always been a sign for negative future growth. The broader money supply (as measured by M2) has slowed sharply. It's growing more apparent that it is not a matter of “if” the slowdown will occur, but rather only a matter of “when”. We’ve already kept an underweight in equities, raised cash levels, locked some rates in, and extended some bond duration in anticipation. In terms of stocks, it is a conundrum: Equities rarely have two bad years in a row (since 1950 the S & P 500 Index has only seen consecutive calendar years of negative returns only…. three times) and last year’s action may already have incorporated much of the bad economic news we see ahead.
Another market factoid which helps the bulls: The Presidential Cycle. Year three of the President’s term (which 2023 is) has historically been the most robust, with an average return of get this: 16.8% for the S & P 500 since 1950 and a win ratio (i.e . positive returns) of nearly 90%.
Canada may be done with its rate hikes, the US may have one more time, another 0.25%, and that may be it. And then rate cuts will follow at some point. If the Fed ends up cutting interest rates early, our guess is commodities will rip (rise big time).
We suspect volatility will remain, but that volatility is an inherent characteristic of owning equities and always creates opportunities to invest in companies at attractive prices. It’s most likely the playbook for investing in the past decade will be different going forward, the “easy money” era is over. There will be new leadership, and value, hard assets (commodities), stock picking, and short duration cash flows may come into vogue again, its been some time for all of them.
Stay tuned,
Vito
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