- The market and economy are facing mixed signals.
- The yield curve and leading economic indicators are predicting recession.
- The negative effect of higher interest rates has yet to filter through the economy.
- Valuations have expanded significantly driven primarily by speculation, not fundamentals.
- The market is likely to become more volatile over the coming months.
- We remain cautious on the market, but we are ready to shift back into “Normal” when market opportunities present themselves.
Mixed Signals for Markets and the Economy
Mixed signals for the economy and markets prevailed in the second quarter of 2023. Forward-looking recession indicators such as LEI and yield curve inversions continued to flash red, while housing, manufacturing and job growth flashed green. Markets also produced mixed signals with the Nasdaq Composite recording its best first half ever while most stocks languished. The Nasdaq rose 12.8% for the quarter versus the Russell 1000 Equal Weight +1.7%. Early stages of a new bull market are typically characterized by strong breadth – strong performance across all types of companies and industries – which is different from what we are currently experiencing. A small number of stocks continue to represent the bulk of market gains this year.
Valuations bottomed last October as pessimism peaked. Since that time the S&P 500 P/E has expanded 26.8% (see below) from 15.3x to 19.4x, with stock prices up only 24.4%. With earnings down, P/Es represent 110% of the market increase reflecting gains fueled by speculation, not fundamentals.
For these higher multiples to stick, much stronger earnings growth needs to be delivered through the remainder of the year, which is unlikely. Rapidly declining producer prices (PPI) with still high consumer prices (CPI) are beginning to lift corporate profit margins temporarily but are unlikely to be enough to support lofty valuations. In addition, high P/Es and high interest rates are incompatible. The Fed’s continued hawkish stance means higher rates for longer, which is bearish for stock multiples. We have likely reached peak multiples this year which means further gains must be driven by earnings growth. This may be elusive if monetary tightening begins to manifest itself in slower economic growth, albeit on a longer lag than has historically been observed.
Yield Curve Predictor = Recession but Fiscal Stimulus Powerful Offset
Our outlook for the economy continues to include a recession sometime later this year or next as the higher cost of borrowing begins to take a toll on growth. Our caution rests on a few tenets, including a deeply inverted yield curve that has predicted 8 of the last 8 recessions, money supply (M2) shrinkage which will reduce market liquidity, falling corporate profits which are unlikely to bottom any time soon, bank lending standards that are tightening and have historically led to job losses, the negative impact of interest rate hikes working on a lag but have yet to bring inflation down to target, and the liquidity drain associated with the Fed’s shrinking balance sheet (QT) at a time when deficit spending and US Treasury issuance is ramping up.
Offsetting these headwinds is the almost $5 trillion in stimulus spending propping up growth for the next few years as those funds make their way into the economy. This excess fiscal spending is frustrating the Fed’s goal of bringing inflation down and may cause them to hold rates higher than expectations, which could lead to a deeper recession. Recession is a fool-proof way to kill inflation and represents the Fed’s last resort if prices do not fall further on their own. Prices are moderating in some areas, but Core PCE, the Fed’s primary inflation measure, remains stubbornly high, hovering around 5% for the past two years.
If inflation eases through the back half of the year and the Fed pulls back from their hawkish stance, corporate earnings could begin to bottom after declining for the past four quarters. Small Cap earnings have been hit hardest, down almost 20%, while large cap earnings have declined 6%. A recovery would likely benefit small companies the most, as is typical in a cyclical recovery. Bullish indicators for stocks include improving investor confidence, benign credit spreads on bonds, and low market volatility. Investors have moved from extreme pessimism (last October) to extreme optimism over the past few months based on better-than-expected economic growth and speculation over the potential growth boost from artificial intelligence (AI). Market volatility is seasonal and tends to be lower in the first half of the year, increasing in July through October, then falling again in November and December. Periods of low volatility are associated with prices gradually rising and high volatility with prices fluctuating more and often falling. After a very calm quarter, we may be in for bigger market swings over the next few months as the outlook for the remainder of the year comes into sharper focus. There is also seasonality in growth expectations with optimistic company earnings at the beginning of the year guided down beginning in the summer reality hits, which is often less rosy than hoped. This also contributes to relatively poor market performance from August-October. Strong stock market performance this year is discounting strong early cycle earnings growth in the second half, but we believe it is premature to assume an early-stage recovery when the negative effects of higher interest rates have yet filter through the economy. Our view is that we are in the latest stage of an economic expansion that began in 2009. The expansion was on its last leg by early 2020 but was artificially boosted by unprecedented levels of monetary and fiscal stimulus in response to COVID-19 shutdowns, extending it far beyond its natural course.
Focus on Protecting Assets
We remain cautious overall and have positioned portfolio allocations towards “Protect.” However, we are ready to shift back into “Normal” when market opportunities present themselves. We would define this as fundamentals catching up with prices or a meaningful market correction that brings valuations more in line with our economic and earnings growth outlook. For now, higher yields on cash and bonds, combined with still strong, risk-adjusted expected returns on alternatives, make the opportunity cost of being underweight equity targets low.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer
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