April 2024 Market Update: Will the Real Fed Funds Rate Please Stand Up

1. In March, global equity markets rose sharply for the second consecutive month.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 ETF in grey).

Since the end of October 2023, U.S. stocks have sizzled. Emerging markets have been dragged down by China.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), IWM (iShares Russell 2000 ETF in grey), and MCHI (iShares MSCI China ETF in red).

2. Will the real federal funds rate please stand up? Inflation remains the most important story for markets. Increased uncertainty over the FOMC’s reaction function adds a new element.

(reader note: real federal funds rate = effective federal funds rate – inflation rate

The headline inflation rate has dropped to about 1% above pre-pandemic levels.

The “core” inflation rate (excludes food and energy) remains 2% above pre-pandemic levels.

The improvement (downtrend) in the rate of inflation has stalled over the last several months. As a result, the FOMC has sat on the sidelines and the effective federal funds rate has sat at 5.33% for the last eight months.

What gives?

From a supply perspective, labor force and energy supply have been the big constraints.

• Ongoing skills mismatches have led to high wage growth in certain industries, e.g., pilots and machine workers.

• Higher energy and electricity costs are a result of years of underinvestment in oil exploration and production and nuclear energy generation.

On the margin, other constraints have limited supply, in particular:

• Underinvestment in infrastructure.

• Increasing regulation in various industries.

• Incoherent immigration policy.

• Geopolitical frictions.

From a demand perspective, there have been two “surprises”.

• The “long and variable lag” of monetary policy tightening in reducing economic demand has been quite long versus historical precedent and not as impactful as projected.

  • Many large corporations extended debt maturities when interest rates were low pre-2022.

  • Since the U.S. housing market is largely financed with 15-year and 30-year fixed rate mortgages, most existing homeowners have not faced re-financing risk.

  • Many household and business had significant cash holdings or built-up cash holdings during the pandemic and have benefitted from higher interest income.

• The U.S. federal government has engaged in an unprecedented spending spree over the last several years, which has boosted demand but has not boosted supply.

The deflationary forces of globalization, competition and technology innovation have yet to win out. Maybe they will.

In the meantime, what is the Federal Reserve (FOMC) to do?

The FOMC has three official mandates, namely maintain full employment, keep prices stable, and serve as lender of last resort in a crisis. The FOMC has also operated as if it has a fourth mandate, namely support risky asset prices. Over the last four decades, the Fed has not had to worry about price stability. Globalization was a strong deflationary force.

Now it faces the challenge of balancing its mandates.

• Maintaining full employment is particularly important in an election year.

• After a strong rally, U.S. large cap equity valuation multiples appear to be factoring in federal funds rate cuts.

• Many banks are facing the prospect of credit losses on commercial real estate loans (mostly offices in urban centers) and credit losses on leveraged loans as the rise in short term interest rates starts to bite. On the other hand, financial conditions remain loose, according to the Chicago Fed’s National Financial Conditions Index.

• Inflation, especially services inflation, has proven sticky. Wage growth in the services sectors is still hovering around a 5% annual growth rate. The Atlanta Fed's sticky-price consumer price index (CPI), a weighted basket of items that change price relatively slowly was up 4.4% on a year-over-year basis in February.

Investors keep changing their expectation for rate cuts. In October, investors were pricing in three rate cuts (using the upper end of current federal funds rate range of 5.25% to 5.50%). By January, they were pricing in seven rate cuts. By the end of March, they are back to pricing in three rate cuts.

The options market has detected the lack of a clear signal about near term FOMC policy actions.

In the Federal Reserve’s December 2023 note “Elevated Option-Implied Interest Rate Volatility and Downside Risks to Economic Activity”, author Cisil Sarisoy commented on the rise in uncertainty about short term interest rates.

“Measures of uncertainty about U.S. short maturity interest rates derived from options have risen sharply since October 2021, reaching their highest levels in more than a decade. This note first uses survey-based measures of economic uncertainty to argue that this increase in option-implied measures likely reflect higher uncertainty about inflation, the associated monetary policy response, and the perceived resulting downside risks to economic activity. It further shows that increases in implied volatility over the past twenty years have generally been associated with lower future economic activity and larger downside risks.”

3. Credit markets will likely be the canary in the coal mine, as the typically are, if a sustained economic contraction, is forthcoming and large federal funds rate cuts are on the horizon.

At month end March 2024. high yield bond spreads remained subdued and had settled around 1.5% below long-term averages and well below recent peaks.

U.S. leveraged loan default rates also remained subdued, per data from PitchBook | LCD.

March 2024 Market Update: Supercore and Superfour

1. Prices for Services excluding Energy and Housing in the Personal Consumption Expenditure metric, a.k.a. Supercore PCE, spiked in January. Was it a blip or an indication of a resurgence in inflationary pressures?

Inflation remains the most important story for markets.

In January, the prices for services excluding energy and housing within personal consumption expenditures jumped 0.6% month over month. It was one of the four highest month over month increases since the beginning of 2021. Services prices have been much stickier than goods prices and represent the risk that the rate of inflation does not return to its 2% pre-pandemic trend.

The Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, but at a gradual rate. Wage growth is to the extent it reflects a virtuous cycle of sustainable economic activity supported by strong productivity growth. However, it still appears much of the wage growth is tied to structural supply shortages in the labor market.

Higher inflation is problematic for investors and financial markets. Not only does higher inflation translate to higher interest rates and borrowing costs, but it also leads to lower multiples and lower investment returns. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The rate of inflation peaked in the late summer 2022 but has not retraced its rise on the way down. It appears to have settled above its pre-pandemic range.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has plateaued in recent months.

The “Core” inflation rate (excludes food and energy) has proven even stickier and remains 2% above pre-pandemic levels.

2. Global equity markets rose sharply in February, led by China, which has been the big laggard over the prior three months.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), IWM (iShares Russell 2000 ETF in grey), and MCHI (iShares MSCI China ETF in red).

Since the end of October 2023, U.S. stocks have sizzled.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), IWM (iShares Russell 2000 ETF in grey), and MCHI (iShares MSCI China ETF in red).

3. In the first two months of 2024, performance of the so-called Magnificent Seven has diverged. It looks more like the Super Four.

This chart shows the performance of NVDA (NVIDIA Corporation in orange), META (Meta Platforms, Inc. in blue), AMZN (Amazon.com, Inc. in yellow), MSFT (Microsoft Corporation in purple), SPY (SPDR S&P 500 Index ETF in grey), GOOGLE (Alphabet Inc. in red), AAPL (Apple Inc. in green), and TSLA (Tesla, Inc. in blue/grey).

Year-to-date, NVDA, META, AMZN, and MSFT have outperformed the S&P 500 Index, while GOOGL, AAPL, and TSLA have underperformed.

4. Treasury yields rose across the curve in February, with the three-year yield experiencing the biggest jump.

Source: www.treasury.gov, Two Centuries Investments

5. Credit markets will likely be the canary in the coal mine, as the typically are, if a sustained economic contraction is forthcoming.  

At month end February 2024. high yield bond spreads remained subdued and had settled around 1.5% below long-term averages and well below recent peaks. Good news for sure.

February 2024 Market Update: A Difficult Juggling Act

1. Global equity markets stumbled out of the gate in January with U.S. large cap stocks and Japan stocks as the only major categories to finish the month in the green.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), IWM (iShares Russell 2000 ETF in grey), MCHI (iShares MSCI China ETF in red), and EWJ (iShares MSCI Japan ETF in green).

A slow start to the year is not surprising given the swift and strong global equity market rally over the last two months of 2023.

2. Treasury yields barely budged in January after the sharp decline into year-end.

Source: www.treasury.gov, Two Centuries Investments

3. Inflation remains the most important story for markets.

Inflation impacts the level and shape of the Treasury yield curve. Inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and lower investment returns. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The rate of inflation peaked in the late summer 2022 but has not retraced its rise on the way down. It appears to have settled above its pre-pandemic range.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has plateaued in recent months.

The “Core” inflation rate (excludes food and energy) has proven even stickier and remains 2% above pre-pandemic levels.

4. The Federal Reserve faces a juggling act between employment, inflation, and its “other” mandate of ensuring financial system stability.

Structural supply shortages, most notably in the labor market, have reduced the effectiveness of tighter monetary policy in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. All else equal, less demand means lower wage growth and lower prices.

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Over the last several months, United Airlines, American Airlines, and Southwest Airlines pilots were able to negotiate approximately 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years and the UAW (United Auto Workers) negotiated 25% general pay increases plus cost-of-living adjustments over the next four years for the Big 3 auto workers.

The housing market is also experiencing a supply shortage. Despite higher mortgage loan rates, demand for housing remains high due to a demographic bump (children of baby boomers) in the age cohort (ages 25-40) with the highest percentage of new home buyers.

In addition, when interest rates were low prior to the 2022 spike, many corporations refinanced debt and either increased maturities or increased the percentage of fixed rate debt relative to floating rate debt. In other words, they companies have yet to feel the full brunt of the increase in interest rates. Over the next five years, over $4 trillion in corporate bonds will need to be refinanced at higher yields, as illustrated by the chart below from Calamos Investments, who used data sourced from the ICE BofA US Corporate Index and the ICE BofA High Yield Index, as of 10/19/23.

Bloomberg published a similar chart on September 29, 2023 showing the debt maturity wall for U.S. and European issuers.

Lastly, the Fed needs to consider the impact of shrinking its balance sheet on intermediate and long maturity Treasury yields at a time when the Department of the U.S. Treasury will be increasing the percentage of notes and bonds it issues going forward and reducing the percentage of Treasury bills.

In summary, the Federal Reserve is hoping to avoid dealing with any further trade-off between real GDP growth (the volume of goods and services being transacted) and inflation (the price of goods and services being transacted). The Fed also has to be careful not to further impair the capital position of the regional banks, most of whom are dealing with increased credit losses on commercial real estate loans. Recent comments from Federal Open Market Committee voting members reveal the Fed is more worried about a provoking a recession and damaging credit creation by banks than it is about pushing inflation lower in the near term.

5. Despite the Federal Reserve raising the federal funds rate target by 5.25% over a relatively short period, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

6. Industrial activity and the manufacturing sector remain mired near recession levels, despite pockets of strong activity.

The recent weakness in industrial activity is apparent when viewed in the context of five-year and thirty-year trends.

With 46% of S&P 500 companies having reported quarterly earnings, the sectors with the lowest revenue growth are energy, materials, utilities, and industrials, namely the sectors most closely tied to industrial activity. The solid revenue growth in the information technology sector has been largely driven by software companies, while the semi-conductor companies most closely tied to industrial activity have reported weak revenue growth.

7. Economic growth has been supported by a massive increase in fiscal spending.

This fiscal deficit is still at levels only seen during recessionary periods when tax receipts decline and fiscal spending increases.

8. Consumer spending has been the other pillar of economic activity.

However, U.S. consumer debt growth is running well above economic growth. The strength in consumer spending is increasingly driven by borrowing and less by wage income growth, a concerning development.

9. Inventory levels bear watching.

As of November 2023. the inventory-to-sales ratio had risen from post pandemic lows to the upper end of its post 2002 range.

10. Credit markets will likely be the canary in the coal mine, as the typically are, if a sustained economic contraction is forthcoming.  

At month end January 2024. high yield bond spreads had settled around 1.5% below long-term averages and well below recent peaks. Good news for sure.

January 2024 Market Update: A Swift Rebound in Equity Markets at Year End

1. Global equity markets rallied for the second straight month in December.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. The two-month rally was swift and strong. Small cap equities led the way in the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

3. Global equities had an excellent year, led by the so-called magnificent seven U.S. mega-cap stocks. China was the big laggard.

4. From a factor perspective in the U.S. equity market, high beta stocks were the outperformers in December and for full year 2023, while low volatility stocks were the laggards.

These charts show the performance of SPY (SPDR S&P 500 Index ETF in purple), SPHB (Invesco S&P 500 High Beta ETF in green), and SPLV (Invesco S&P 500 Low Volatility ETF in red).

5. Treasury yields declined sharply over the last two months of the year, following the historically unusual bear steepening from mid-July through the end of October.

Source: www.treasury.gov, Two Centuries Investments

 6. As we repeated throughput 2023, what lies ahead for financial markets will likely be driven by the path and composition of inflation.

The concern about inflation has likely contributed to the bear steepening of the yield curve. Inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2% above pre-pandemic levels.

7. Despite the Federal Reserve raising the federal funds rate by 5% over the last twenty months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

8. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Over the last several months, United Airlines, American Airlines, and Southwest Airlines pilots were able to negotiate approximately 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years and the UAW (United Auto Workers) negotiated 25% general pay increases plus cost-of-living adjustments over the next four years for the Big 3 auto workers.

9. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy and the multi-month bear steepening of the yield curve.

At year end 2023. high yield bond spreads had settled around 1.5% below long-term averages and well below recent peaks.

10. Overnight reverse repurchase agreements continue to decline. These agreements have served as a source of financial market liquidity. We are concerned financial market volatility may rise once the amount of these agreements outstanding approaches zero.

December 2023 Market Update: That De-Escalated Quickly

“That escalated quickly” is a phrase uttered by Ron Burgundy in the 2004 movie, Anchorman: The Legend of Ron Burgundy. By “that de-escalated quickly”, we mean the burgeoning U.S. Treasury bond market crisis de-escalted quickly in November.

1. Global equity markets rebounded after three months of declines, boosted by the sharp reversal in U.S. long-term Treasury bond yields.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey), and TLT (iShares 20+ Year Treasury Bond ETF in dashed green).

2. The burgeoning Treasury bond market crisis de-escalated quickly. The bear steepening ceased after three and half months, and long matured Treasury yields declined sharply, approaching the levels of August month end.

Source: www.treasury.gov, Two Centuries Investments

A bear steepening is commonly defined as a double-digit basis point increase in the difference between the 10-year Treasury and 2-year Treasury yield. A bear steepening is a rare occurrence, especially when the yield curve is inverted like it is currently.

The table below from Janus Henderson illustrates the historical rarity.

·       The orange highlighted rows map to bear steepening off inverted yield curves.

·       The blue highlighted rows map to bear steepening off relatively flat curves.

·       The green highlighted rows map to bear steepening off very steep curves.

Our hypothesis remains the bond market was likely communicating a supply digestion concern. We are not certain the supply digestion problem is fully resolved. However, in November the bond market took notice of the continuing moderation of inflation and a downtrend in real economic growth. Odds increased the FOMC will cut the Federal Funds Rate multiple times in 2024.

3. As we keep repeating, what lies ahead for financial markets will likely be driven by the path and composition of inflation.

The concern about inflation has likely contributed to the bear steepening of the yield curve. Inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has risen over the last three months.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2% above pre-pandemic levels.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last eighteen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Over the last several months, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years and the UAW (United Auto Workers) negotiated 25% general pay increases plus cost-of-living adjustments over the next four years for the Big 3 auto workers.

6. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy and the multi-month bear steepening of the yield curve.

7. Over the last two months, one of the best performing asset classes has been gold, which traded at all time highs recently and currently sits at over $2,000 per ounce.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey), and GLD (SPDR Gold Trust in dashed gold).

November 2023 Market Update: The Bond Vigilantes Ride Again

1. The global equity market weakness continued for another month in October, likely triggered by the jump in long maturity U.S. Treasury yields.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey), and TLT (iShares 20+ Year Treasury Bond ETF in dashed red).

2. The U.S. Treasury yield curve continued its bear steepening behavior. Long maturity U.S. Treasury yields jumped, while short maturity U.S. Treasury yields barely moved.

Since the end of August, the ten-year U.S. Treasury note yield has risen 76 basis points, while the two-year U.S. Treasury note yield has risen a paltry 17 basis points, representing a steepening of 59 basis points.

Source: treasury.gov, Two Centuries Investments

A bear steepening is commonly defined as a double-digit basis point increase in the difference between the 10-year Treasury and 2-year Treasury yield. A bear steepening is a rare occurrence, especially when the yield curve is inverted like it is currently.

The table below from Janus Henderson illustrates the historical rarity.

·       The orange highlighted rows map to bear steepening off inverted yield curves.

·       The blue highlighted rows map to bear steepening off relatively flat curves.

·       The green highlighted rows map to bear steepening off very steep curves.

What message could the bond market be communicating?

Are the “bond vigilantes” back, demanding higher yields to protest the Federal Reserve’s policies, as they supposedly did during the early 1980s according to economist Ed Yardeni, who coined the “bond vigilante” phrase?

Are the “bond vigilantes” back like they supposedly were during the 1994 Great Bond Massacre, protesting concerns about federal government spending levels? During the 1994 crisis, Clinton Administration political adviser James Carville referenced the “bond vigilantes” when he said, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

We argue the current situation is a straightforward supply and demand issue. The bond market sees ongoing large auctions of Treasury notes and bonds on the horizon, as federal government spending remains at elevated relative to a few years ago, federal tax revenues have been in decline since the end of 2022, and the U.S. Treasury Department shifts away from its reliance on Treasury bill issuance. There will be a jump in the supply of longer maturity notes and bonds.

What about buyers, i.e., demand, for the increased supply? Most importantly, the Federal Reserve ended its Quantitative Easing program and is reducing the size of its balance sheet. It was a big buyer of Treasuries, and a price insensitive one at that. China and Japan have curtailed their purchases of Treasuries, whether for geo-political or domestic reasons. U.S. banks already have too much interest rate duration as the regional bank crisis highlighted in March 2023. Defined benefit pension funds and traditional life insurers, once large natural buyers of long maturity Treasuries, are in decline.

Price sensitive buyers realized they can garner more income on Treasury bills and short-term Treasury notes than longer maturity Treasury notes and bonds. A 5+% rate also feels good after years of near zero short term rates. Yes, cash equivalents pose reinvestment risk, but the other side of the coin is assuming considerable duration risk when inflation is not yet back to its low and stable pre-pandemic levels.

In summary, the bond market is likely communicating a supply digestion concern, The problem is higher long maturity interest rates at this stage of the economic cycle create tighter financial conditions, especially for the housing market which is largely financed by fifteen-year and thirty-year mortgage loans. Home construction and renovation have been large contributors to economic growth. In summary, the incremental tightening of financial conditions reduces the probability of a soft landing for the economy.

3. As we keep repeating, what lies ahead for financial markets will likely be driven by the path and composition of inflation.

The concern about inflation has likely contributed to the bear steepening of the yield curve and the tighter financial conditions. Inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has risen over the last three months.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2% above pre-pandemic levels. If not for the ongoing bear steepening of the yield curve, the sticky core inflation rate might compel the Federal Reserve to keep raising short term interest rates in an attempt to dampen economic demand and push inflation back towards its 2% target.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last eighteen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years and the UAW (United Auto Workers) negotiated 25% general pay increases plus cost-of-living adjustments over the next four years for the Big 3 auto workers.

6. The S&P 500 Index may achieve year-over-year earnings growth, an outcome last seen in the third quarter of 2022.

With 81% of the companies in the index having provide quarterly earnings reports, the earnings growth rate is tracking at 3.7% year-over-year, while the revenue growth rate is 2.3%.

7. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy and the recent bear steepening.

High yield bond spreads remain near long term averages and below recent peaks.

October 2023 Market Update: The Unholy Trinity Surfaces

1. The global equity market weakness continued in September.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. The unholy trinity of rising oil prices, increasing U.S. interest rates, and a strengthening U.S. dollar is pressuring asset prices.

Since July 13, crude oil prices have risen approximately $12 per barrel (14% price increase), the U.S. dollar has risen approximately 7%, and the ten-year U.S. Treasury note yield has risen 83 basis points. In a world accustomed to low-cost energy, dependent on a cheap reserve currency for facilitating global trade, and addicted to low interest rates for financing, simultaneous increases in the levels of these three financial variables is a threat to global economic activity and asset prices. Stocks, bonds, and gold have responded negatively to the rise of the unholy trinity.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), WM (iShares Russell 2000 ETF in grey), GLD (SPDR Gold Trust in yellow), TLT (iShares 20 Plus Year Treasury Bond ETF in red), CO1 (Brent crude oil futures contract in black), TBX (ProShares Short 7-10 Year Treasury ETF in light blue), and DXY (U.S. Dollar Index in green).

3. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has risen the last two months.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2.5% above pre-pandemic levels. A sticky core inflation rate might compel the Federal Reserve to keep raising short term interest rates in an attempt to dampen economic demand and push inflation back towards its 2% target. More tightening of monetary policy risks a severe economic downturn.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last eighteen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

The Atlanta Federal Reserve Bank’s GDP Now estimate of 4.9% real economic growth for the third quarter 2023 lends credence to the view that GDI will rise to close the gap to GDP.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years. Currently, the UAW (United Auto Workers) is demanding a 46% pay deal and FedEx pilots are demanding a 30% pay rise.

The unemployment rate remains nears its lows over the last four decades.

6. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy.

High yield bond spreads remain near long-term averages, and 2% below the most recent peak of 6% in July 2022.

September 2023 Market Update: Inflation Remains Sticky

1. The global equity market rally stalled in August.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels as food and energy costs have declined.

This chart shows the price of a barrel of WTI crude oil (source: CNBC).

Energy costs appear to have bottomed as crude oil prices have risen $18 per barrel over the last two months, making further declines in headline inflation dependent on the trend in services inflation.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and almost 3% above pre-pandemic levels.

3. Despite the Federal Reserve raising the federal funds rate by 5% over the last seventeen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data points to an economic slowdown.

The Atlanta Federal Reserve Bank’s GDP Now estimate of 5.6% real economic growth for the third quarter 2023 lends credence to the view that GDI will rise to close the gap to GDP.

4. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. Currently, the UAW (United Auto Workers) is demanding a 46% pay deal and FedEx pilots are demanding a 30% pay rise.

The unemployment rate remains nears its lows over the last four decades.

5. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy.

High yield bond spreads remain near long-term averages, and 2% below the most recent peak of 6% in July 2022.

August 2023 Market Update

1. July was the second consecutive strong month for global equity markets.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in dark grey).

U.S. small-cap stocks were the star performers for the second consecutive month.

2. While the year-to-date outperformance of U.S. large cap equities remains intact, U.S. small cap and emerging markets equities have closed the gap over the last two months.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in dark grey).

We would not be surprised if U.S. small cap, non-US developed markets and emerging markets equities continue to outperform U.S. large cap equities. Over the last five years, U.S. large cap has outperformed both U.S. small cap and non-US developed markets by around 50% and has outperformed emerging markets by over 70%.

3. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate is now only 1% above pre-pandemic levels.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains almost 3% above pre-pandemic levels.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last sixteen months, real economic growth has not collapsed, though it remains muted.

According to the "advance" estimate from the U.S. Bureau of Economic Analysis, real gross domestic product (GDP) even picked up from its recent trend, increasing at an annual rate of 2.4% in the second quarter of 2023.

Real gross domestic income (GDI) data for the second quarter is not yet available. The GDI data diverged from the GDP data in first quarter and pointed to an economic slowdown. These data series will converge, the question is in which direction.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. Currently, the UAW (United Auto Workers) is demanding a 46% pay increase deal and FedEx pilots are demanding a 30% pay rise.

Adding to the challenge facing the Federal Reserve is the demand for mortgage loans is contracting at a much slower pace. The rapid rise in mortgage rates in 2022 crushed mortgage loan issuance and appeared to be putting the brakes on housing construction. As housing construction remains an important driver of economic activity, any sustained strength in construction activity will contribute to inflationary pressure.

Lastly, crude oil prices have risen recently. Continued strength in oil prices will put upward pressure on headline inflation, potentially make core inflation stickier, and further complicate the Federal Reserve’s balancing act.

6. Corporate earnings growth in the second quarter 2023, while better than expected, was still the weakest growth in almost three years.

With 84% of the companies in the S&P 500 Index having reported quarterly earnings, earnings declined 5.2% and revenues declined 0.6%, year over year.

7. While most of the world is dealing with inflationary pressures and many central banks are still raising short-term interest rates, in contrast China is facing the risk of a credit crisis and deflation.

This chart shows the People’s Bank of China one-year medium term funding rate versus the U.S. Federal Reserve’s federal funds rate (overnight rate)

China’s central bank, the PBoC, once again cut its one-year medium-term lending facility (MLF) rate, to 2.50% on August 15th, as it seeks to support economic growth weighed down by a deepening property crisis and muted consumer spending.

Country Garden, a real estate developer with $194 billion in liabilities at year end 2022, missed payments of $22.5 million on two of its offshore dollar bonds. Trading in eleven of its onshore bonds was suspended. A default appears to be a foregone conclusion.

China Evergrande, once China’s largest property developer by sales, filed for Chapter 15 bankruptcy in New York on August 17. Its meltdown began in September 2021 and triggered a chain of failures across the Chinese property sector, which is estimated to represent as high as 30% of China’s GDP. We discussed Evergrande in our December update (December 2021 Market Update).

How the Chinese government navigates the real estate crisis bears monitoring for two reasons.

• The Chinese economy is a significant source of demand for commodities.

• Any large depreciation of China’s currency, the renminbi, could have a large impact on global trade and financial flows.

July 2023 Market Update: Strong Equity Rebound Continues...What Lies Ahead?

1. June was a strong month for the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in green).

In June, U.S. equity markets outperformed non-US equity markets. U.S. small cap stocks outperformed U.S. large cap stocks after lagging their larger cap peers since the regional bank crisis in March.

2. Year-to-date trends remain intact, with large cap U.S. equities leading the way and emerging market equities as the laggard, dragged down by China.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in green).

3. The powerful rally in U.S. growth stocks has propelled the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), IWF (iShares Russell 1000 Growth ETF in blue), IWD (iShares Russell 1000 Value ETF in orange).

Year-to-date, U.S. large cap growth stock universe has generated a 30% return.

4. Year-to-date, other asset classes have provided modest returns.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), IWM (iShares Russell 2000 ETF in green), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in blue), GLD (SPDR Gold Trust ETF in yellow), and TLT (iShares 20+ Year Treasury Bond ETF in orange).

5. An examination of performance over the last 18 months is a sober reminder financial markets have not fully recovered from the carnage of the first nine months of 2022.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), IWM (iShares Russell 2000 ETF in green), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in blue), GLD (SPDR Gold Trust ETF in yellow), aTLT (iShares 20+ Year Treasury Bond ETF in orange), IWF (iShares Russell 1000 Growth ETF in red), IWD (iShares Russell 1000 Value ETF in gray).

6. What lies ahead for financial markets will be likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation (and deflation) has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs, thus boosting corporate profit margins.

Producer prices have already declined back to pre-pandemic levels.

Consumer prices have continued to decline but remain around 2% above pre-pandemic levels.

Wage growth remains strong in many segments of the labor market. The stickiness of higher wage growth remains a headwind to profit margins.

7. Global trade volumes are declining and manufacturing surveys point ot continued weakness.

Source: John Kemp (Reuters)

8. Corporate earnings reports for the second quarter are just around the corner. The results and management commentary will provide some clarity on the economic outlook, now that the pandemic related distortion of economic collapse / economic surge / economic normalization is entering the rear view mirror.

The results from early reporter FedEx Corp. (ticker: FDX) were not reassuring. All three FedEx segments (Express, Ground, Freight) experienced volume declines and management is forecasting “flat to low-single-digit-percent revenue growth year over year” for fiscal year 2024.

9. While manufacturing and global trade exhibit sustained weakness, consumer spending on services and most of the service sector have chugged along.

What could disrupt this consumer momentum, outside of the obvious job losses, which is a lagging indicator?

(1) Refinancing risk for loans, especially mortgages, either in the form of higher interest rates (compared to 2021) and tighter bank lending standards, likely driven by the aftershocks of the March 2023 regional bank crisis.

Source: treasury.gov, Two Centuries Investments

(2) Higher energy prices, namely higher crude oil prices.

Source: John Kemp (Reuters)

Crude oil prices remain well below the recent 2022 peak.

June 2023 Market Update: Large Liquid Mega Caps, Large Language Models, and Long Lag Monetary Policy

1. On the surface, May was a quiet month for U.S. financial markets.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), TLT (iShares 20 Plus Year Treasury Bond ETF in green), LQD (iShares iBoxx $ Investment Grade Corporate Bond ETF in red), HYG (iShares iBoxx $ High Yield Corporate Bond ETF in orange), IWM (iShares Russell 2000 Index in blue), and GLD (SPDR Gold Trust in yellow).

U.S. large cap equities, US small cap equities, U.S. high yield debt, U.S. investment grade debt, long maturity U.S. Treasury bonds, and gold all generated returns in a narrow band between +1% and -1% in the month of May.

2. However there was considerable dispersion within the U.S. equity markets.

This chart shows the price performance of IWF (iShares Russell 1000 Growth ETF in purple), SPY (SPDR S&P 500 Index ETF in yellow), RSP (Invesco S&P 500 Equal Weight ETF in green), IWD (iShares Russell 1000 Value ETF in blue), and SPYD (SPDR Portfolio S&P 500 High Dividend ETF in orange).

Growth stocks outperformed value stocks by more than 8%. The market cap weighted S&P 500 Index outperformed an equally weighted index of S&P 500 constituents by more than 4%. High dividend stocks were the worst performing style (factor), underperforming the S&P 500 by over 8% and underperforming growth stocks by over 12%.

This chart shows the price performance of IWF (iShares Russell 1000 Growth ETF in purple), SPY (SPDR S&P 500 Index ETF in yellow), RSP (Invesco S&P 500 Equal Weight ETF in green), IWD (iShares Russell 1000 Value ETF in blue), and SPYD (SPDR Portfolio S&P 500 High Dividend ETF in orange).

The year-to-date performance dispersion is even more stark. Growth stocks have outperformed high dividend stocks by an astounding 32%.

3. Large liquid mega cap stocks remain the standout performers.

This chart shows the returns for the following stocks. NVDA = NVIDIA Corporation; META = Meta Platforms, Inc.; TSLA = Tesla Inc.; AAPL = Apple Inc.; AMZN = Amazon.com, Inc.; GOOGL = Alphabet Inc.; MSFT = Microsoft Corp.

These seven mega cap stocks were under performers for most of 2022. All are also considered beneficiaries of trend towards Artificial Intelligence, the most well known applications being autonomous driving systems and ChatGPT with its large language model.

4. The Artificial Intelligence business opportunity has also been a tailwind for certain computer hardwire providers, including some semiconductor stocks.

This chart shows the returns for the following stocks. NVDA = NVIDIA Corporation; AMD = Advanced Micro Devices, Inc.; SMCI = Super Micro Computer Inc.

5. U.S. equity market valuations look expensive at current levels of economic growth and inflation.

Source: Yardeni Research

6. Real economic activity has remained muted over the last four quarters.

This chart shows the year over year change in real gross domestic product.

The good news is the much ballyhooed recession has not materialized. The concern is real economic activity below a 2% growth rate will not translate to the strong corporate revenue growth needed to offset profit margin pressure, especially with no economic growth tailwinds from China and Europe.

7. Producer prices have already declined back to pre-pandemic levels. Consumer prices have remained stickier and well above pre-pandemic levels. Wage growth remains strong in many segments of the labor market.

A continued decline in inflation will ease the pressure on corporate profit margins. However, lower wages represent a trade-off, namely lower consumer spending but lower costs for companies.

8. The boom in federal government spending is behind us.

The pandemic related federal government spending boom supported corporate profit margins and likely delayed the full impact of monetary policy tightening on the economy.

9. Commercial banks are tightening credit standard for loans. The tightening started before the bank crisis in March and has picked up steam since then.

Tightening credit standards for loans is a lagged impact of tighter monetary policy. It will be a headwind for economic growth.

10. What happens going forward for both the economy and financial markets will depend on the continued emergence of the “long and variable lags” of monetary policy. The fog is starting to lift.

May 2023 Market Update: Bank Stress Takes the Front Page from Inflation

1. Despite the failure of a third large U.S. bank, the U.S. equity market rose in April.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

2. April continued the year-to-date trend of non-US developed market equities leading the way higher, while emerging market equities continue to lag.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

3. While the US equity market has risen almost 10% year-to-date though the end of April, there has been massive performance dispersion within the market.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), XLK (Technology Select Sector SPDR ETF in green), and KRE (SPDR S&P Regional Banking ETF in red).

Technology stock prices have bounced higher, with the sector generating a year-to-date return in excess of 20%. On the other hand, the bank crisis has crushed regional bank stocks, which have crashed by more than 25% year-to-date through the end of April.

4. The regional bank crisis has yet to be resolved, highlighted by the failure of First Republic Bank and its sale at a discounted valuation to JP Morgan Chase & Company.

First Republic Bank was a large regional bank, with $165 billion in deposits as of December 31, 2022.

As we noted in last month’s update, over a two-year period ending in early 2022, many banks experienced rapid balance sheet growth due to an influx of deposits. The banks invested the deposits to earn higher interest income, but took significant interest rate risk in the process. In 2022, the spike in interest rates across the yield curve led to unrealized losses on securities and loans and reduced the capital (solvency) of most banks.

Adding to the solvency concerns for regional banks is rising delinquencies for commercial real estate loans, especially office and retail loans.

On the other side of the balance sheet, the spike in short term interest rates exposes the banks to disintermediation (deposits being withdrawn and moved to money market funds) and to higher funding costs to replace lost deposits. Together, these factors reduce the future net interest income (earnings) needed to replenish the capital.

Worst of all is uninsured depositors who travel in the same personal and professional circles. Silicon Valley Bank (SVB) and First Republic Bank (FRB) had well above average exposure to these “hot money” depositors.

Not only aren’t they “sticky” depositors, they don’t act independently and their behavior is highly correlated. Their risk profile is reminiscent of the subprime borrowers of the 2008 Global Financial Crisis, a group whose default behavior was highly correlated once stress hit the financial system.

Once these depositors initiated large and rapid deposits withdrawals, the fates of SVB and FRB were sealed. Selling a large percentage of assets with unrealized losses crystallizes insolvency. Replacing a large percentage of existing deposit funding, even with Federal Home Loan Bank (FHLB) secured borrowing available, is near impossible and will result in negative earnings for the near term as funding costs will exceed interest on assets.

The chart below, from Moody’s Analytics, shows the banking system funding stress has reached 2008 Global Financial Crisis levels.

The chart below shows the build up of deposits in smaller banks during the pandemic, driven by the massive government stimulus programs, and the recent accelerated decline.

5. Even if the bank crisis gets resolved in the near term, the events of March and April will lead to risk aversion by many banks. Combined with rising credit provisions, banks will continue to tighten lending standards, creating a headwind for economic growth.

Source: federalreserve.gov

Source: federalreserve.gov

According to the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, banks have been tightening lending standards on loans since July 2022.

The tightening of credit standards is running into increased demand for loans from U.S. consumers.

6. The bank funding stress has yet to show up in the high yield debt market as credit spreads remain quite muted relative to prior recessions and crises.

7. Corporate earnings season confirmed businesses are still dealing with cost pressures, though the pressure is moderating.

With 85% of S&P 500 companies having reported earnings, year over year revenue growth was a modest 3.9%. However, earnings declined 2.2%, though less than the 4.6% decline in the prior quarter. Operating profit margins are below their recent peak, and have stopped their rapid decline. With companies facing moderating top line growth and a higher cost of capital, the path of profit margins will assume increased importance.

April 2023 Market Update: Bank of Charts, pun intended

1. Despite the failure of two large U.S. banks, the equity market rose in March.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), KBE (SPDR S&P Bank ETF in purple), and KRE (SPDR S&P Regional Banking ETF) in orange.

In March, bank stocks experienced sharp declines as three well known banks failed, namely Silicon Valley Bank, Signature Bank, and Silvergate Bank. Silicon Valley Bank had over $200 billion in assets and Signature Bank had over $100 billion in assets as of December 31, 2022.

Over a two-year period ending in early 2022, many banks experienced rapid balance sheet growth and increased interest rate risk to earn a higher return. The spike in interest rates in 2022 led to unrealized losses on securities and loans and damaged the solvency of most banks.

That said, Silicon Valley Bank was an outlier and will serve as a case study on how not to do interest rate risk management.

To the extent the banks do not experience a rapid rise in credit losses, akin to what happened during the Global Financial Crisis of 2008, a banking crisis is highly unlikely. Most banks can access financing from the combination of the capital markets and the Federal Reserve as they deal with the unwind of rapid deposit growth.

Source: Bloomberg

The current decline in bank deposits and corresponding rise in money market fund assets looks like a replay of the late 1970s / early 1980s.

Source: @MaxfieldOnBanks, The San Francisco Examiner - December 27, 1981

2. Certainly, the events of March will lead to higher financing costs for banks. Combined with rising credit provisions, banks will continue to tighten lending standards, creating a headwind for economic growth.

Source: federalreserve.gov

According to the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, banks have been tightening lending standards on Commerical & Industrial loans since July 2022. Even more severe has been the tightening the Commercial Real Estate loans.

Source: federalreserve.gov

After a period of decline from the pandemic peak, commercial mortgage loan delinquency rates have started to creep up. The special servicing rate (loans that have been modified due to default) has been rising since mid 2022.

This chart shows delinquency. special servicing, and grace rates for CMBS (commercial mortgage-backed securities).

The delinquent loan rate has started to rise before the outstanding balance of delinquent loans returned to pre-pandemic loans.

3. Despite some signs of stress in the loan market, the high yield debt market remains sanguine. Credit spreads remain below the the highs of 2022, and well below crisis peaks.

4. The yield curve has become more inverted since the beginning of the year, signaling increasing concerns about future economic growth.

Source: treasury.gov, Two Centuries Investments

5. U.S. manufacturing activity is already contracting. Manufacturing output is more volatile than service sector output and typically leads the services sector.

ISM Manufacturing PMI (Purchasing Manager Index)

Source: March 2023 Manufacturing ISM® Report On Business®

New orders remain weak.

ISM Manufacturing PMI: New Orders component

Source: March 2023 Manufacturing ISM® Report On Business®

6. China’s manufacturing activity is rolling over, a surprising outcome given China only fully reopened its economy late last year.

The weakness in both US and China manufacturing activity is concerning.

7. Inflation continues to decline and is currently running at a 6% annual rate after peaking at 9% in mid 2022.

The big unknown is whether the decline in the inflation rate will continue to be symmetric to its rise. We suspect it will be over the next few months, but are concerned the rate will plateau near 4%.

8. A continued moderation in inflation will benefit businesses who have faced declining profitability during the recent two year period of above historical average inflation.

March 2023 Market Update: Waiting Patiently

The title says it all. We are waiting patiently for more data, especially inflation data. Inflation has peaked, but its rate of decline has slowed, and where it settles is what matters most.

1. February was a weak though uneventful month for global equity markets.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), and EEM (iShares MSCI Emerging Markets ETF in orange).

2. Corporate earnings season confirmed businesses are still dealing with cost pressures.

With 99% of S&P 500 companies having reported earnings, year over year revenue growth was solid 6.3%. However, earnings declined 4.6%. Profit margins declined in eight of the eleven sectors. The energy, industrials, and real estate sectors were the three exceptions.

3. The tightness in many segments of the labor market will continue to be a headwind for profit margins. Our bigger concern is the Federal Reserve’s reaction function if inflation remains sticky above a 4% level.

On March 1, Minneapolis Federal Reserve Bank President Neel Kashkari commented, "I think my colleagues agree with me that the risk of undertightening is greater than the risk of overtightening”.

If the Federal Reserve resumes more aggressive monetary tightening, the risk of a policy error will jump and a recession in the near term will be the likely economic outcome.

February 2023 Market Update: Stranger Things (in the U.S. Equity Market)

1. The composition of the U.S. equity market performance in January qualifies as one of the stranger things I have seen in my career.

In January, the U.S. equity market market rose 6.3% (as proxied by the S&P 500 Index). I wasn’t surprised risk assets started the year with a strong upward bounce as the U.S. equity market declined 18.1% in 2022. Nor was I surprised high beta stocks outperformed low volatility stocks after underperforming low volatility stocks by 15.7% in 2022, though the degree of outperformance, by 19.3%, was a bit surprising. Some mean reversion was likely for both the market overall and for underlying equity factors. Risk on.

What was “Upside Down”, given the aforementioned mean reversion in both the overall market and high beta vs. low volatility, was the lack of mean reversion in the performance of growth stocks vs. value stocks. Growth underperformed Value by 1.4% in January after underperforming by 24.2% in 2022. Pure Growth did even worse on a relative basis, underperforming Pure Value by 7.9%.

Source: S&P Dow Jones Indices LLC. This chart shows equity factor performance in January 2023, using the S&P DJI factor methodology.

Source: S&P Dow Jones Indices LLC. This chart shows equity factor performance for the calendar year 2022, using the S&P DJI factor methodology.

Even stranger was the growth vs. value performance when considering history. Value stocks typically underperform growth stocks in risk on markets. January 2023 was definitely an anomaly, especially for pure value vs. pure growth. A supernatural force at work?

Source: S&P Dow Jones Indices LLC.

2. January was a banner month for all major asset classes.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), GLD (SPDR Gold Trust ETF in dotted yellow), HYG (iShares iBoxx USD High Yield Corporate Bond ETF in dashed light blue), TLT (iShares 20+ Year Treasury Bond ETF in dashed light blue) and IEF (iShares 7-10 Year Treasury Bond ETF in dashed red.)

3. Inflation as measured by CPI-U may be moderating, but businesses are still dealing with cost pressures that have resulted in earnings declines despite revenue growth.

With 50% of S&P 500 companies having reported earnings as of February 3, year over year revenue growth is estimated to be a modest 4.3%. However, earnings are estimated to decline 5.3%. Only the energy, industrials, and real estate sectors are showing both revenue growth and earnings growth.

4. The paths forward for the U.S. equity market and the U.S. economy remain encased in heavy fog, a view introduced in last month in our 2023 year ahend outlook commentary.

From my perspective, the two debt market charts below encapsulate the divergent messages being sent to investors.

The Treasury yield curve remains inverted, and is even more inverted than it was at year end. Interest rates, via the inverted yield curve, are signaling economic weakness and maybe even deflationary pressure is on the horizon.

Source: treasury.gov, Two Centuries Investments

On the other hand, the credit markets remain sanguine. High yield credit spreads fell 51 basis points in January, are 120 basis points below their most recent peak at the end of September, and are 169 basis points below their 2022 peak in early July.

Credit markets are signaling the U.S. economy is weathering the large and rapid tightening of monetary policy.

If credit markets are correct, the question will become at what level inflation settles. If the level is too high, the Federal Reserve will likely be forced to resume more aggressive monetary tightening. The risk of a policy error and an ensuing recession would become likely.

At this stage, we are monitoring for economic and financial market data for clues.

January 2023 Market Update & Year Ahead Outlook: Credit Risk Takes the Wheel

1. Inflation risk and interest rate risk drove financial market performance in 2022, not just for bonds, but also for stocks.

In its November 3, 2021 statement, the FOMC asserted “…Inflation is elevated, largely reflecting factors that are expected to be transitory.” Inflation, as measured by CPI-U, proved less transitory than the Fed thought, rising an additional 3.6% from 5.4% to a peak of 9% in June 2022.

In 2022, the FOMC raised the target range for the Federal Funds Rate by 425 basis points to 4.25% - 4.50% in an attempt to dampen inflation.

Source: Forbes Advisor

For the first four months of the year, the Treasury yield curve steepened, signaling continued Fed rate increases, higher inflation, and a shift in demand for Treasuries relative to the supply of Treasuries. In the back half of the year, the yield curve flattened and finished the year slightly inverted, signaling slower economic growth on the horizon.

Source: treasury.gov, Two Centuries Investments

Because of their higher interest rate sensitivity (higher duration), long maturity Treasury portfolios experienced large declines, in the neighborhood of 30% drawdowns.

This chart shows the price performance of IEF (iShares 7-10 Year Treasury Bond ETF in purple) and TLT (iShares 20+ Year Treasury Bond ETF in blue).

The long duration equivalent in the equity market, namely growth stocks, declined by a similar percentage, also near 30%, as measured by the performance of the Russell 1000 Growth Index. The growth stock headwind dragged down the performance of the U.S. equity market, with the S&P 500 Index barely avoiding a 20% drawdown for the year.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in purple), and IWG (iShares Russell 1000 Growth Index ETF in blue).

2. As we enter 2023, inflationary pressures are moderating. Interest rates for longer maturity Treasuries are likely approaching a peak.

Global supply chain issues have lessened, especially in the global shipping network. The prices of many goods are falling as the pandemic induced demand bounce has ended. Shipping container rates have plummeted towards pre-pandemic levels.

Source: Flexport

Prices have fallen rapidly for used passenger vehicles and computer hardware as previously spiking during the pandemic. Housing rents are rolling over, though the impact has yet to appear in the shelter cost component of CPI-U. The housing market faces the headwind of higher mortgage loan interest rates. Food price increases have likely peaked and energy prices have fallen, though we would caution against expecting further energy price declines.

With inflation moderating and no large tailwind for real economic growth, we suspect interest rates are approaching a peak.

3. Service sector inflation and wage pressures, along with de-globalization trends, will likely put a higher floor under inflation in the near term.

The labor market remain tight, largely due to the supply side. In particular, many older workers left the labor force during the pandemic and are not expected to return. The number of unemployed persons per job opening is at a low level relative to both recent history and the entire post World War II period.

Geopolitical tensions, especially with China, mean supply chains will be adjusted, resulting in higher costs. In addition, the massive influx of low cost Chinese labor into the global economy is over. China’s population has likely peaked. Wages in China have risen significantly over the last decade.

4. While U.S. equity market valuation multiples have contracted, the market is facing profitability headwinds due to higher expenses.

Much higher labor, materials, and equipment costs have reversed the trend of increasing operating profit margins. Higher interest expense and higher taxes will be additional headwinds to net income margins and earnings per share growth.

Source: spglobal.com, Two Centuries Investments

Non-US developed markets equities and emerging markets equities appear more attractive. Europe is facing energy related cost pressure due to the Russia-Ukraine conflict and China is facing a real estate crisis as it emerges from its zero-Covid economic activity restrictions, but valuation multiples outside the U.S. embed a lot of bad news already.

Source: Yardeni Research

5. The path forward for the U.S. equity market is encased in heavy fog. We suspect the path will be inseparable from the path of credit risk.

The heavy fog is due to several factors.

• The new floor for inflation is impossible to predict.

• The lagged effect of a sizable and rapid tightening of monetary policy on economic activity is difficult to predict.

• The Fed’s reaction function is difficult to predict as the Fed balances inflation risk vs. recession risk.

• China’s new trend line of economic growth is difficult to predict.

• The damage done to the European economy from the Russia-Ukraine conflict and the accompanying energy crisis is difficult to predict.

If the Fed leans too hard in the direction of crushing inflation, an economic downturn is a near certainty and will manifest itself in rapidly rising credit risk.

On the consumer front, we are monitoring credit card delinquencies. We do know consumers are running down the savings they built up during the pandemic.

Note: Data from July 1, 2012 to July 1, 2022

Credit card balances increased by over 10% annualized in the second and third quarters of 2022.

Source: New York Fed Consumer Credit Panel/Equifax

On the business front, we are monitoring corporate credit spreads, especially for below investment grade debt.

Leveraged loans (floating rate loans for lower quality issuers) experienced over 300 basis points in rate increases (higher interest expense) in 2022.

Source: Eaton Vance, data through September 30, 2022

Higher operating expenses and interest expense are starting to take a toll on some companies as the percentage of distressed loans has increased. However, the percentage is well below crisis levels.

Source: Eaton Vance, data through September 30, 2022

High yield debt spreads have risen 175 basis points from post pandemic lows, but still remain well below crisis levels.

6. Increased credit risk will translate to higher U.S. equity market volatility, even if a recession is not a near term outcome. We suspect the odds favor non-US equities, Treasuries, and gold relative to U.S. equities in 2023. Within U.S. equities, robust business models are the likely winners, with strong and sustained free cash flow growth, strong intangible assets, and / or revenues tied to commodities with structural supply issues.

December 2022 Market Update: Markets Rally, Cryptonite Captivates

1. In November, almost every class exhibited a reversal of trend. Global equities rallied, led by non-US equity markets. Long maturity U.S. Treasuries rose in price and the U.S. dollar declined modestly.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 Index ETF in yellow), TLT (iShares 20+ Year Treasury Bond ETF in red) and DXY (U.S. Dollar Index in green) .

Year-to-date, equities and long maturity Treasury portfolios remain significantly underwater.

This chart shows the price performance of SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in purple), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 Index ETF in yellow), TLT (iShares 20+ Year Treasury Bond ETF in red) and DXY (U.S. Dollar Index in green) .

2. In October, U.S. inflation rate (as measured by CPI-U) fell to 7.7% from September 8.2% and June’s 9.0% rate, which was the highest annual rate since the 1970s.

The moderation in inflation was likely a contributor to the reversal of the trend of asset class performance. If inflation continues to moderate at the pace experienced in October, it will facilitate an earlier end to the tightening of monetary policy.

3. While equity risk, interest rate risk, and inflation risk have hammered asset class performance this year, credit risk remains muted. We anticipate the trend in credit risk will drive financial market performance over the course of the next year.

While high yield credit spreads have risen almost 150 basis points year-to-date as of November 30, the level of credit spreads remains quite low compared to the last 25 years. From our perspective, the big question going forward is whether the combination of inflationary pressures, tighter monetary policy, and economic imbalances precipitate a credit crisis.

4. Is the lack of container ship backlog at the Ports of Los Angeles and Long Beach the proverbial canary in the coal mine?

Source: Freightwaves.com

As we noted late last year and earlier this year, strong demand for goods, supply chain issues, and global shipping network challenges led to an unprecedented container ship backlog at the Ports of Los Angeles and Long Beach. The backlog has evaporated. On November 22 and 23, there were no container ships waiting offshore at the ports.

Certainly, the global supply chain has adjusted as pandemic related economic restrictions have been removed. Certainly, there was a pull forward in demand for goods, so there will be a period of below trend demand. However, the labor, equipment, and warehouse issues at the ports have not been resolved. Thus, our concern is the lack of a backlog may be signaling economic weakness.

5. Credit risk has emerged in a few pockets of the economy. most notably in the cryptocurrency industry. The FTX bankruptcy filing was the latest and biggest outbreak of credit risk in the industry. As with almost every credit crisis these days, the cryptonite was financial engineering.

In last month’s monthly update, I noted “Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.”

Part of the financial engineering revolved around the concept of yield farming, whereby cryptocurrency owners could lend their cryptocurrency and receive a high interest rate, much higher than rate in a commercial bank savings account or the yield on a money market fund.

This concept befuddled me, as cryptocurrencies do not generate cash flows, so it seemed much riskier than traditional securities lending (applied to stocks and bonds).

Many cryptocurrency companies engaged in yield farming also held low amounts of equity capital, i.e., they were highly levered. Commercial banks are required to hold higher equity capital and the banks even have the benefit of access to the Federal Reserve’s discount window.

In addition, the so-called cryptocurrency exchanges did not operate like traditional stock, commodity, and derivative exchanges, by managing counter-party (credit) risk tightly via daily, and often high, margin requirements.

Lastly, there seems to have been an incestuous relationship between several cryptocurrencies and cryptocurrency companies, meaning the cryptocurrencies and businesses were highly correlated.

Note 1: I am ignoring the allegations of fraud and focusing only on the structural problem of financial engineering, since it relates to my concern about credit risk lurking below the surface of the economy. While frauds can be large, they will be contained. Credit risk in systematic form is the big danger; it is hard to contain.

Note 2: Not all cryptocurrency industry players engaged in financial engineering, as some act as true custodians of customer assets, supported by compliance, risk management, and audit systems.

November 2022 Market Update: WhatsUpp with Financial Markets, META, and Crypto

1. In October, global equity markets rebounded, with the big exception being China, which weighed on emerging markets performance. Year-to-date, equities remain significantly underwater.

This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).

The Chinese stock market was the big outlier, reacting poorly to the outcome of the Communist Party Congress. Chinese Premier Xi Jinping will remain as leader for an historic third five-year term and be surrounded by loyalists in the Politburo. This concentration of power raised the concern China will be less focused on economic growth and more focused on domestic wealth inequality and national security issues. Zero-Covid policy, with associated activity restrictions, will also remain intact.

This chart shows the price performance SPY (SPDR S&P 500 Index ETF in blue), EFA (iShares MSCI EAFE ETF in orange), EEM (iShares MSCI Emerging Markets ETF in purple), and MCHI (iShares MSCI China ETF in yellow).

Has the sell-off in stocks finally ended? We doubt it for two reasons.

First, we haven’t witnessed the widespread investor despair that typically accompanies equity market bottoms. Second, the Federal Reserve will need to continue to tighten monetary policy to lower inflation to a more acceptable level.

That said, to the extent a credit crisis does not develop, we don’t anticipate anything like the equity market carnage we witnessed in the 2008 Global Financial Crisis.

2. In September, U.S. inflation rate (as measured by CPI-U) barely fell to a 8.2% from August’s 8.3% and June’s 9.0% rate, which was the highest annual rate since the 1970s.

We anticipate inflation in the U.S. to moderate as the demand for goods continues to ease post pandemic. However, labor market challenges, structurally higher energy prices, and supply chain challenges emanating from China will put a floor on the intermediate term range for inflation.

3. US interest rates continued their rise, wreaking havoc on all major asset classes, as the Federal Reserve raised the Federal Funds Rate target by 0.75% in October. The Fed has raised the rate by 3.50% so far in 2022.

Source: treasury.gov, Two Centuries Investments

4. Corporate earnings season highlighted the impact of rising expenses on earnings growth for many companies. Ex-energy, earnings growth will be negative for the S&P 500 for the second consecutive quarter.

As of November 4, 85% of the companies in the S&P 500 had reported quarterly earnings results for the third quarter of 2022. No surprise, the energy sector continues to be the star performer. Notably, the industrial sector also has shown strong revenue and earnings growth. The communication services, financials, and materials sectors have experienced double digit earnings declines, year over year.

While revenues grew 10.5% year-over-year, earnings growth only grew 2.2% as higher expenses lowered profit margins.

Labor cost growth is the primary culprit and is currently running about 200 basis points higher than its pre-pandemic trend.

5. Many companies with seemingly robust business models have performed poorly this year. Below, I briefly discuss the issues facing META, a company which scores highly in the “brand” category of our Focused Quality equity model. I use a discounted cash flow model framework.

META, which owns Facebook, Instagram, and WhatsApp, reported earnings on October 26 after the stock market close. On October 27, META's stock price declined 24%. Year-to-date through the end of October, the stock price had declined 72%. What happened to META, a company which is one the big three, along with GOOGL and AMZN, in the growing and oligopolistic digital advertising industry?

Certainly, higher interest rates have contributed to a higher equity discount rate (all else equal, namely the equity risk premium). This factor has impacted higher growth stocks, which have longer "durations", as more of the cash flows to equity shareholders are further out in the future. GOOGL was impacted similarly. Think of it as a contributor to valuation multiple compression.

The boost in digital advertising during the pandemic has ended. The economy is also slowing and advertisers are reducing all forms of spending. META faced the additional headwind of AAPL allowing iPhone owners to change their privacy settings to limit tracking by advertisers. In other words, revenue growth has slowed.

Higher operating expenses, including higher labor costs, reduced profitability as profit margins declined. Lastly, META committed to maintaining much higher capital expenditures (over $32 billion in 2022) to develop the "metaverse" and expand their artificial intelligence capabilities. There is no guarantee these expenditures will produce anywhere near the high Return on Invested Capital (ROIC) produced by META’s core advertising business.

Comparing 3q2022 to 3q2021...

Revenues declined from $29.0 billion to $27.7 billion.

Net Income declined from $9.2 billion to $4.4 billion.

Cash Flow from Operations declined from $14.1 billion to $9.7 billion.

Capital Expenditures increased from $4.3 billion to $9.4 billion.

“Free Cash Flow” declined from $9.8 billion to $0.3 billion.

In summary, lower revenues, higher operating expenses, and valuation multiple compression hit the stock, like they have hit other growth stocks this year. But two other META specific issues have led to additional underperformance, namely AAPL’s business decision and META’s decision to spend aggressively to build a new business at as time when most companies are spending cautiously due to emerging economic growth headwinds.

6. As I was writing this monthly update, news broke about the failure of FTX, one of the largest cryptocurrency exchanges. While we await more details, I will highlight a few principles, likely applicable to the FTX situation and which we articulate to our clients who are considering investing in crypto.

1) Know the protections available, or not available, with the safekeeping of your assets.

2) Understand cryptocurrencies are illiquid, intangible assets which do not generate cash flows, at least not organically. As a result, they do not represent quality collateral for lending.

3) Be wary of a financial market exchange that has not subjected itself to the rules and best practices governing public financial market exchanges. In the FTX situation, FTX engaged in a related party transaction with the hedge fund Alameda Research.

4) Research the legal framework and creditor status that will be applicable if an insolvency occurs.