“We are navigating by the stars under cloudy skies.”
- Fed Chair Jerome Powell at Jackson Hole, 8/25/2023
“How did you go bankrupt? Two ways. Gradually, then suddenly.”
- Ernest Hemingway, The Sun Also Rises
One epigraph alone seems insufficient preface for a comment amid market and economic conditions so shaken and unsettled as are these. Adding geopolitics, CIA director William J. Burns recently described this time as “one of those rare plastic moments of genuine transformation that come along once or twice in a century…”
Consider that the credit rating of the US Government was recently downgraded, autoworkers are on strike, oil prices have risen to top $100/bbl, China’s real estate market has been collapsing as its economy struggles, and student loan repayments resume this month after a long hiatus, potentially slowing the spending of a significant portion of the population. Bank lending has tightened and credit to commercial real estate is essentially cut off. Interest rates are at 16-year highs and Federal Reserve Chairman Powell recently said we should expect rates to be higher for longer. The bond market’s “yield curve” structure continues to be inverted (with short interest rates higher than long rates), a condition that presaged each recession for several decades – and ditto for the Leading Indicator Index. War still rages in Ukraine as Putin still threatens with his nukes. Per the polls, next year’s presidential election looks likely to be a rematch unwelcomed by most. While some believe a general excess of pandemic-related cash has held off recession so far, aside from the wealthiest 20%, Americans now have less cash on hand than they did before the Pandemic started. And overhanging all is the fact that the conditions that caused the regional bank crisis in the Spring – losses in bond portfolios because of high interest rates - essentially remain.
Diane Swonk, chief economist at KPMG, recently said, “It’s becoming a series of unfortunate events…The soft landing is being jeopardized.”
However, economic growth for the quarter is widely expected to have been quite robust. Moreover, after hitting a multi-year low of 3.4% in April, unemployment at last measure (August) remains a relatively low 3.8%, and new unemployment claims continue to be very low.
Touching all of the above in various ways is inflation, which reached a four-decade high of 9.1% in June last year, declined to 3.1% this July, and has since moved back up to 3.7% annually. And driving inflation - with “long and variable” lags - is money supply growth. The most widely used measure of the money supply is M2, and M2 growth exploded in 2020, peaking at +26.9% annually in February 2021. Inflation followed. Since then, money supply growth declined and slipped into contraction in December of 2022, remaining negative since, with its latest 12-month growth rate being -3.67% as of August. This is the only contraction in M2 since the Great Depression - we are in exceptionally rare territory here.
Government shutdowns and strikes get lots of press but don’t really matter much to markets and the economy, and politics habitually impacts markets in the long term less than most believe. But that still leaves several important and contradictory indicators: On the one hand, we have the recent surprising strength in the economy and labor markets, and material declines in inflation rates. On the other, there is the relationship of short to long-term interest rates (the “yield curve”) the negative reading from the “Leading Economic Indicators,” and the rare decline in the money supply. It may be tempting to conclude that here we have a set of powerful indicators that are simply at odds with one another, and that uncertainty is therefore even greater than usual. But closer inspection reveals an important pattern: all the positive measures pertain to recent and past conditions, while all the negative signals are forward-looking. That is a sobering observation.
We also note that the federal deficit approximately doubled this year compared to last. For the fiscal year that just ended on September 30, the federal deficit is expected to be about $2 trillion, up from about $1 trillion last year. As a share of the economy, there is zero precedent for deficits this large outside of war, recession, or pandemic. First Trust’s chief economist Brian Westbury calls it “fiscal madness.” He concludes, “The party continues for now, but a hangover looms in our future.”
Consider the contrast between the behavior of the government and the public: When rates were so low for many years, consumers and businesses refinanced mortgages and other debt, locking in very low long-term rates. Only the government largely failed to refinance its debt with low rates then. Moreover, the average maturity of US Treasury debt is now only 6.25 years, meaning that about half of all the US Treasury debt must roll over and reprice to likely higher, then-prevailing interest rates over the next six years or so.
Legislators on both sides of the aisle have demonstrated remarkable capacity for deficit spending, so large deficits may well continue beyond reasonable expectation, but higher interest rates and exploding debt-service costs will eventually set limits. Regardless of when a reckoning may occur, this current explosion in federal spending may go a long way toward explaining the strength of the recent positive economic indicators, and the delays in the impact of the forward-looking negative economic signals just recounted.
We’re pleased the economy has been strong of late and that most models have recently reduced their probability of recession. But broader evidence demands that caution remains in order.
This year so far, the most common bond benchmark index is down a little more than 1% and the blended stock index is up 9.5%. After declining over 6% from 7/31 through 9/30, the S&P 500 Index remains up just over 13% for the year (with both small stocks and international stocks lagging), REITs are down 5.6%, and the Swiss Re Cap Bond Index of certain insurance-linked securities leads all with a return of over 15% so far this year to date. S&P 500 Index returns are misleading, however, as at many points through the year, just 7 large stocks accounted for over 99% of the index return while the other 493 stocks in the index were essentially flat. Such an extreme condition of return concentration is neither normal nor sustainable, and in fact, that extremity has normalized somewhat in the past two months. (As this is written – 10/3/2023 – both the S&P 500 Equal Weight Index and the Dow Jones Industrial Average have slipped into negative year to date returns.)
Given all these circumstances, we are generally holding full target positions of cash – something that rarely, if ever, occurred in recent decades prior to last year because of then low interest rates. Additionally, we are working to hold portfolio bond durations (think: average maturities) close to market index durations – neither longer nor shorter after being generally shorter for years (which was a help as rates began to rise). Higher interest rates now make bonds more attractive and help boost portfolio income which in turn helps stabilize portfolio returns.
A diversified portfolio balanced among stocks, bonds, cash, real estate, and alternatives increases the dependability of returns over time. Moreover, with conditions as unsettled and uncertain as they are now and with stock and bond markets at odds as noted in prior comments, the benefit of a little increased dependability could become even more valuable.