“Confusion now hath made his masterpiece!” ― McDuff in Shakespeare’s The Tragedy of Macbeth
“Give me a one-handed Economist. All my economists say 'on the one hand, this, but on the other hand, that...” ― Harry Truman
With the S&P 500 Index up over 16% this year to date, the stock market is focused on how much inflation has moderated without a recession. On the other hand, the bond market signals a recession comes. This counterpose is not new, and we’ve commented on it here before, but it’s more extreme now.
And that’s not the only extreme condition in markets. In the first half, markets worked through the worst banking crisis since 2008, and the largest US debt ceiling crisis since 2013, yet the Tech-concentrated NASDAQ Index, up more than 30% so far this year, registered its largest gain for the first half of a year in 40 years.
Stock price growth has exceeded growth in earnings and other fundamentals, so already high market valuations are now higher.
Treasury bond yields rose a little this year, and short-term Treasury rates rose a lot. The condition in which short-term treasury rates are higher than long-term rates is known as an “inverted yield curve” and is more extreme now than it has been in decades. This is the condition in bonds that portends a coming recession. It’s not certain if this merely predicts recession or reflects monetary conditions sufficient to cause one, but its accuracy in leading recessions has been historically good: this occurred 11 times in the past 55 years, and each time was followed by a recession starting between 6 and 18 months later. Stock returns in the 15 months following a yield curve inversion have been mixed but biased to the downside, ranging between -47% and +12%. The S&P 500 is now up 13% since the current inversion of the yield curve, and if it just stayed flat through year-end, it would be the best stock performance after a yield curve inversion since at least the 1960s.
There is also the Composite Index of Leading Indicators, sometimes referred to as the LEI (Leading Economic Index, published monthly by the Conference Board), which while not as accurate as the yield curve, is now also pointing toward likely recession.
In geopolitics, the anticipated Ukraine offensive has yet to achieve a breakthrough, but the recent flash coup leaves Putin politically wounded. Unfortunately, it’s hard to imagine that will be a stabilizing influence on one who has threatened repeatedly to use his nuclear arsenal.
On the positive side, employment remains strong: there are about two job openings for each job seeker, the consumer is still spending, and corporate profit margins have been strong. GDP estimates for the first quarter were just revised upward from 1.4% to 2% per year above inflation. However, the Gross Domestic Income measure slumped in the first quarter (in theory, the two should be equal, but because of measurement challenges, they seldom are).
That said, Europe has officially slipped into recession. With lots of unrealized losses remaining in government securities holdings, US regional banks are not necessarily out of the woods yet. And corporate bankruptcies have picked up.
Commercial real estate faces strong headwinds from falling office demand and higher borrowing costs. Lenders to commercial real estate are increasingly reluctant to extend new loans when existing loans mature, and more than $1 Trillion in commercial real estate loans are scheduled to mature in the next 18 months.
Quantified in terms of the annual change in the money supply (as measured by M2), monetary conditions are tighter now than at any time since the Great Depression. The Federal Reserve, after raising rates at its fastest pace in many years, paused last month, but Chairman Powell has communicated intent to raise rates again soon.
If that weren’t more than enough, we now also have an extremely “narrow” stock market – that is, a market in which only a few stocks are rising, with the vast majority not so much. For example, as of a month ago, when the S&P 500 was up 9.7% year to date, more than 100% of the market’s gain was then accounted for by just seven large stocks - AAPL, MSFT, NVDA, GOOGL, AMZN, META, and TSLA - with the other 493 being collectively down 0.25% for the year. That’s not a sustainable situation for markets, and it’s particularly unusual to see in what many believe to be the early stages of a new bull market since such narrowness tends to occur very late in bull market cycles. Sooner or later, something must give.
Altogether, this combination is a masterpiece of economic and investing confusion if there ever was one. What do we make of it all, and what’s an investor to do?
First, we don’t think the short-term direction of markets is really knowable. That’s always the case, but it’s especially true when crosscurrents are so extreme. Second, we think the worst course is to pay attention only to these indicators that fit one’s mood (and there are only two moods in investing: fearful or greedy!) while ignoring the multitude of other signals.
One theory holds that tight monetary conditions would have already produced a recession but for lingering growth boost effects of $4.6 Trillion in extra Federal stimulus spending from 2020 - 2022. The thought is that the temporary, “sugar-high” that super-deficit spending produced will eventually (soon?) wear off, delaying but not eliminating the contracting effect of the Fed’s anti-inflation monetary policy. We’ll see.
What we know is that while inflation remains higher than most bond yields, if inflation continues to subside as rapidly as it has been, bonds with yields now much higher than we have seen for several years could quickly become attractive. If inflation keeps coming down AND if a recession and an earnings recession are each avoided, stocks outside of a short list of popular mega-sized companies are not too expensive.
However, core inflation has been much stickier than “headline” inflation, and the inflation measure the Fed watches remains more than double the Fed’s target of 2%. Despite persistent employment strength, the risk of recession remains elevated and has continued to rise. The expensive, large, Tech stocks that led the market this year are not now even remotely priced to discount an earnings recession or worse.
When markets have shown recent strength, commentators nearly always attribute the rise to greater conviction that the Fed’s interest rate increases are nearly finished. That’s a curious reaction that largely ignores history: when the Fed switches its mode and stops raising rates, that’s seldom an “all clear” signal and more often an indication that either a recession is arriving, something in the financial system is “breaking,” or both.
From the perspective of seasonality, the second quarter tends to be the year’s weakest. On the other hand, stocks tend to have a better-than-average second half following a first half as strong as this year’s.
Risks to both stocks and bonds are such that caution continues to be in order. We continue to focus on high quality in bond portfolios, and while last year we kept average bond portfolio maturities shorter where we could, now we’re seeking to match the average maturity of portfolios to that of the bond indexes where possible as rates are higher.
In stocks, we only rarely see such disparity of opportunity with the large Tech stocks that have led the market this year trading at much richer valuations than the rest of the stock market, making them relatively unattractive. However, while stock market risks are quite elevated for the market darlings, valuations (and therefore opportunities) appear much better for most other stocks. International stocks look more compelling than US stocks. Small stocks offer better long-term return prospects than large stocks. Non-Tech stocks look generally more compelling than Tech stocks. Dividend-paying stocks are much more compelling now than non-dividend-paying stocks. And the gap between Value stocks and Growth stocks is considerably wider than usual, with opportunities concentrated in the cheap stocks. One of the investment thought leaders we follow, GMO in Boston, thinks value stocks now represent a “generational” opportunity.
Strong economic crosscurrents are not a reason to embrace the risks of market timing. But a masterpiece of confusion can create significant relative investment opportunities, and the present looks to be no exception in that regard.