As Tom Petty said in his hit song, The Waiting, “the waiting is the hardest part.” That’s very descriptive of our current environment. Markets and investors are waiting for the end of the Fed interest rate hiking cycle, we’re waiting for inflation to come down. Perhaps we’re all waiting for the recession to arrive. Our theme this quarter is waiting can be the hardest part.
Are we prepared for landing?
Back in January, we launched our annual theme, which was prepared for landing. What we meant by that is, what type of economic environment will we see in 2023? The Fed wanted a soft landing, meaning avoiding a recession, perhaps just economic slowdown.
With the Fed hiking rates, historically, that leads to a hard landing or some type of recession, perhaps a severe recession. We thought it would be something in the middle, a bumpy landing. General economic slowdown, perhaps worst case, a mild short-lived recession. We show that the first quarter GDP was 2% annualized. Now that’s in line with average GDP that we saw in the Great Moderation from 2010 to 2020. Not bad at all. We’re waiting for the slowdown. We’re waiting for the recession. Now, in my red circle there you can see later this year, we do expect to have some type of economic slowdown.
Now, for us, it really doesn’t matter if it’s an economic slowdown or a mild recession, as far as how we manage assets. Maybe to make it draw an analogy in the wintertime, whether it’s three degrees out or minus three degrees out, it really doesn’t matter. It’s just cold outside. We think it’s going to get cold in the second half of the year. Our annual theme prepare for landing remains intact that we’ll see this bumpy landing.
It could be deemed a soft landing, but you’ll be close to that zero economic activity in the second half of the year. In a chart, you can see how things rebound quite nicely sometime in 2024. There’s your short-lived mild slowdown or mild recession. Now it’s interesting, as we walk through our presentation, you’ll see that some of the variables we discussed are really sending a green light signal. Things look good. We’re not going to see a recession. We’ll have a soft landing.
At the same time, many variables are blinking yellow. One of the variables that’s perhaps a solid yellow is inflation. This is a focal point for the Fed, a focal point for economic activity.
It’s a story of the year, we’ve been talking about in our conference calls and in all of our team meetings. This is what’s behind everything, including those muted GDP numbers, because those are real GDP numbers after inflation. When you have a high inflation rate, it’s hard to have high economic growth.
They would say that headline inflation is falling off pretty rapidly. We are asked frequently, why is the Fed talking so tough still if headline inflation is falling? The Fed likes to follow PCE instead of CPI. It’s got a little bit different basket.
They like the basket and PCE better for our economy. They’re stuck at that, call it 4.5% to 5% number. They’re not falling as fast as the headline numbers are because Core PCE seems to be a little stuck and moving sideways like the red arrow shows you there. Way above the Fed’s target, which is a light green line across the middle there, 2% to 2.5% is where the Fed wants that Core PCE number.
It’s a full 200 basis points above that and not really moving lower very rapidly. That’s why the Fed’s talking tough. The Fed is saying they still have some more work to do. That’s really what’s underneath all this. That’s why we’re going to be stuck waiting to see what the impact of all the Fed moves are and how much more they have to do.
There’s still good news out there. The Manheim used car index. Used cars through the pandemic, really spiked up. Now we just got new data, it’s down 4.2% in the month of June. That was the largest decline that we’ve seen at least since 2020 and then prior to that 2008. There are still those green light signals that suggest inflation will come down, but not come down fast enough. We get CPI data later this week, we get some new data for the Fed. The next Fed meeting is later in the month to us about what do you think the Fed’s going to do?
Talking tough with the Fed
The Fed is just front and center on all this story right now. The Fed’s probably going to continue to talk tough. It looks like that’s probably the most rational thing, even though it’s been a pretty tough run with them so far, you might say. We’ll look at a couple charts on that right now. You see this is just Fed funds movements over time, really long period of time, 40-plus years. On the right-hand side of the chart, you see what they’ve done thus far, they’ve taken Fed funds up pretty rapidly from basically 0 up to 5.25.
In the red circles along the left side here, you see the big broad cycles. The Fed has typically been tightening for a while. Then they go into a pause mode, a waiting period. Almost every time historically they’ve ended up being blamed for causing a recession. That’s what you see in the vertical gray bars beside that. After a prolonged tightening period, we tend to fall into something that gets called a recession.
On the right-hand side with the steepness of that increase, on one side of the ledger, people saying, “Well, we certainly have to have a recession. This is what always happens when the Fed tightens particularly this much.” This next chart is just maybe graphically a little bit easier way to see how rapidly they have tightened. This is the last six cycles. Along the bottom in green was the 15 to 18 cycle. They were not fighting an inflation problem they were simply trying to normalize from zero.
That doesn’t really correlate to what’s happening now. We looked at this chart last time together as a group also. In the middle, you see the previous five tightening cycles that were associated with an inflation issue when they were trying to address inflation. Along the top in dark, you see current cycle much steeper this time. We’re moving quicker and we’re moving more dramatically than we have in the past because they have more of an inflation problem than they’ve had in a long, long time. In just 15 months or so, we’ve had basically 500 basis points of increase in overnight rates.
The dotted line tells you they’ve already gotten to five and a quarter. It seems relatively certain they’re going to take it to five and a half and they’re probably going to telegraph that they might have some more work to do, because of the stickiness on the other slide, how sticky core inflation looks to be, probably one more, and then talk of a little bit more after that is the best thing to expect for the end of the month.
Some of the data that supports our prepare for landing theme, meaning a slowdown or a mild recession as your previous slide. Historically, every time the Fed gets so aggressive, it naturally slows down the economy.
It will, and before this call started, we were talking about the lag effect. We know it will work and it works with a lag. We’re going to a period of time where we have to wait and see how much all this tightening has impacted us. It takes time and we’re going to find out in the second half of the year how much impact it has.
Now the Fed feels that they have not been aggressive. If they were on the call today, they would want to look at this next slide because they have moved quickly but the Fed looks at the world in terms of real rates. GDP is a real number after inflation. The Fed looks at Fed funds rates adjusted for inflation. What is the real Fed funds rate? Fed funds minus the prevailing inflation rate. That’s what you see on the chart here. This is the real Fed funds rate back in time and how much did they do historically.
Well, this time it looks like they’ve done a lot more than they’ve done in the past. This chart will show you in real terms, overnight rates minus inflation. They have hiked quite a bit higher in previous cycles. The 2020 cycle, they just went through that, that wasn’t an inflation cycle, and the recession was caused by exogenous shocks it wasn’t due to Fed movements.
You look at the previous three cycles and the Fed took real rates up to three, four, 5%, 500 basis points. Historically they’ve moved a lot higher in real terms than they have this time. On the right-hand side, they’ve just gotten into the positive zone. They’ve had to move a lot because inflation is much higher this time than last time. You have to just at least consider they would say they haven’t made things as restrictive as they have in previous cycles yet.They would make the argument they haven’t done anything too damaging just yet.
I think it’s important to take note of the fact that we’ve crossed the Rubicon of zero real Fed funds because this means that for the first time, really with a short exception right before COVID, that cash rates can provide a real positive return. Meaning that you’re not required as an investor to take risk in order to maintain your purchasing power throughout time, which has big implications for the economy and for financial markets.
When risk-free rates go into positive real zone, it changes the conversation. As inflation drops off, they have to be careful to figure out when to pivot so that real rates don’t go too high and cause too much damage. There’s a lot of moving parts that they have to follow.
What’s the Fed’s strategy?
Let’s talk about the Fed strategy. It’s been changing, late last year, they did a step down from 75 basis point heights to 50. First quarter it went from 50 to 25, then they skipped the meeting. What’s next?
Well, a lot of people ask us that, why did they skip? Someone asked us this morning before we started the meeting, why did they skip last time? I don’t understand. They know that there’s a lag on all this. They know it takes time for these moves to take impact and start to really slow our economy down. They’ve made a lot of moves and that’s why they probably took the skip last time.
They needed to give some time and that’s why they started to slow down the increments also. They know they’ve done a lot. They know inflation might drop off and they need some time to see how big that impact is. It takes at least nine months to know what the real impact of interest rate changes are. They’re probably going to make one more move because of what we talked about. I think as a team, we agree they’ll make a move at the end of July.
As a company, we decided they’ll probably have enough evidence to make one more move later in the year, maybe up to 575. That should be followed by a protracted waiting period as they wait through the lag and see what’s really happened and see how inflation responds after that. Our best guess is a move in July and then a move late in the year, and that’s the end of the cycle. If core inflation has dropped off between now and the end of the year, maybe we don’t get that one at the end of the year. That’s what we have in our forecast right now.
Bond market indicators
We always like to look for clues supporting our forecast. One of the clues out there is the bond market. The two-year treasury today is at 4.9%. What did that tell you about the Fed’s forecast?
It tells you there is maybe a disconnect between the bond market and what the Fed is saying. The two-year has been very patient and the 10-year has been very patient waiting for rates to come down because the two and 10-year, they’re a lot lower than the Fed funds rate. You should have an average of Fed funds over the next two years of something in that 4% to 4.5% range, which could mean some pretty dramatic easing as you get into the end of the year next year. That’s really what the two-year and the bond market are telling you, that we’re really getting close to the end of the cycle and the Fed have to ease.
The Fed looks at this very, very closely. It’s a little bit technical, but this is called inflation expectations. Specifically, this is what the world is telling the Fed that they expect inflation to be five years from now. The Fed really, really pays close attention to this. You can see with very little exception, just a short period of time in March of last year the financial markets have been telling the Fed that they’re doing the right thing and they’re going to get inflation under control.
The Fed would get very upset if this spiked up to 2.75 or 3. In the last six months or so, inflation expectations five years forward, have been very steady in the middle of the Fed’s target range. The Fed looks at this and says, the markets are telling us we’re doing the right thing with inflation, it’s going to work and we’re going to get it all under control.
Liquidity in the system
This is liquidity in the system. This supports our forecast of a general economic slowdown and inflation slowly subsiding. Liquidity makes the world go round. This is just a money supply growth.
We saw unprecedented liquidity through the pandemic. 25% money growth that we’ve really never seen before. In the middle of the page is the great recession 2008, 2009, we only saw 10% money supply growth. Back to the right-hand side of the graph, you can see that all of a sudden money supply is tightening. The Fed is taking liquidity out of the system. We’ve seen a contraction year-over-year of something like 4%, which is the first contraction we’ve seen of that magnitude since the 1930s.
Anytime you take liquidity out of the system, you would expect things to slow down economic activity and inflation. Again, supporting Eric’s comments or expect to see in the Fed or expect to see inflation and supporting our prepare for landing theme of some type of economic slowdown. Let’s move on to some of our economic fundamentals and recession indicators and maybe duct tailing into M2 growth.
We’ll talk about the banking situation. We talked about in our last call where there are a number of regional banks that fell into some trouble. All of a sudden, we look at bank deposits on the top pane and lending standards on the bottom pane. Now we believe that banks and credit are the lifeblood of the economy. Back to my earlier comment about liquidity, and if we have credit available, if we have liquidity our businesses grow, the economy grows.
If you don’t have that you’re in a contraction state and typically inflation follows that. The top 10 there, bank deposits, you can see bank deposits have stabilized, but yet they’re still falling. Then banks are getting very, very cautious with their lending standards. You can see on the bottom pane when the lines are above zero, the red line, that means that it’s getting tough to get a loan to grow your business or whatever the case might be or to consume.
This again, supports our prepare for landing theme some type of slowdown and inflation, as Eric pointed out, expectations coming down this data support that. We’ll look at a few other recession indicators and why we think we’ll see a slowdown. Here is one of our favorite recession indicators. The six-month rate of change in Leading Economic Index (LEI). The LEI is a combination of 10 leading indicators. On this graph, you’ve seen it before, we shared this with you, that it has a very reliable track record on predicting looming recessions.
Anytime this index gets below minus three and a half, that’s my dotted red line and you can see historically my red circles. Every time it breaks that three-and-a-half number you are approaching recession or on top of recession. Months ago, we came crashing through that on the right-hand side of the screen and you can see today this index stands at a minus 8.4. Again, there can be nuances, maybe we break the track record on these variables.
Right now, this is sending one of those yellow signals that there are still risks out there in the economy and the markets. We see more supporting evidence in the yield curve.
Yield curve can’t be ignored
It’s really hard to ignore, especially the combination of LEI plus the yield curve. This is the yield curve which is what we call inverted. As a reminder everybody, this is the difference between the two-year and the 10-year treasury note rate when the long-term rates are lower than short-term rates. We also look at the three months relative to 10 years. There are people in both camps that prefer one over the other. We look at both of them.
When both measures of the yield curve slope are negative, meaning the 10-year is below the short end of the curve. Again, like the LEI, it has a very good track record of telling you that some type of recession is coming. It doesn’t tell you what the magnitude of the recession will be. It could be a softish landing, it could be a very mild recession but it’s hard to ignore, much like the LEI, the severity of the inversion is very, very severely inverted this time, more so than normal.
We have to at least acknowledge that you got the LEI signal, you have the slope of the yield curve signal. Honestly, when you combine that with overnight rates getting into positive and restrictive territory, that’s a potent combination of things that we have to acknowledge it’s likely to cause a slowdown that could easily be a recession. Doesn’t tell us magnitudes but it’s very hard to say that we won’t have any kind of a recession.
Let’s look at a variable that’s blinking green and hasn’t wavered. It’s been green for a long, long time. That’s the labor market. If we go to the next slide, I’ll show you. Here’s headline unemployment. Now, the labor market unemployment is not a leading indicator but nevertheless, we know that unemployment starts to go up as we enter in a recession.
You can see unemployment right here going back to 1981. Typically, in those shaded periods of recession, you see unemployment going up, a coincident indicator, not a leading indicator, but way on the right-hand side, really since March of 2022, unemployment’s been stuck in a range between 3.4% and 3.7%. Last month it was 3.7%. We just got new data, it’s down to 3.6%. From time to time, we do get investors asking us if we’re in a recession right now.
It’s hard to suggest we’re in a recession right now with the labor market being so strong. Now, we do think that will slowly change. Let me show you, let me plop in new data on top of this, things that we look at to suggest recessions are here would be unemployment rate in blue. In light blue, I show you US non-farm payroll growth. The percent change in payrolls that companies are footing FTEs, full-time equivalents on their payrolls.
You can see again on the light blue line that in those periods of oncoming recessions in my circles, lo and behold, payroll growth starts to wane. It gets down to about 1% is our trigger. Even though you have positive payroll growth, you could enter into a recession. Way on the right-hand side, it’s coming down, yes, but it’s at 2.7%. Again, nowhere near our trigger. The labor market suggests an all-clear green light. Everything’s fine, there’s maybe a slowdown coming but clearly no recession.
There’s other data I’ll just show you which gives us some clue on what might happen. We do expect unemployment to go up. You’ve been hearing about layoffs since the beginning of the year, many times these large technology companies that perhaps over hired through the pandemic are laying off people. Here I show you initial jobless claims. People filing for unemployment insurance are on the rise.
You can see on the right-hand side there the trend is up but we found at least historically, is you need to get initial unemployment claims in the 300 to 400,000 range before you can really see a recession coming. On the right-hand side, you can see 258 and I might suggest back to payroll growth. Now in June, we put 209,000 new jobs on the payroll, and our six-month average for the first half of the year, 278,000.
Now, that can change quickly but again, supports we’re not in a recession. As this trend here in claims continues to rise, it could definitely turn to a yellow signal and support our slowdown in the second half of the year, maybe in the fourth quarter to perhaps a mild recession. Hopefully, that provides you with a lot of evidence of why we feel this way and the data supports our forecast. Let’s turn to the financial markets. It’s interesting, here we are waiting, it’s become the hardest part.
Stock market success
If we look at risk-based assets using the stock market as a proxy, stock market’s done pretty well. Just going off headlines, 2023 does seem like it would’ve been a tough year for stocks. Yet here we are halfway through the year with stocks up nearly 17% now. The big question is why? A big reason is just the strong performance from some of the biggest names, think names like Apple, Amazon, Nvidia. In fact, only seven companies are now responsible for almost three-quarters of the S&P’s first-half returns. Really a lot of these gains stem from just the excitement around the future of AI.
Now, as a result, many investors have now become concerned about the potential effects that this top-heavy market could have on future returns, especially if momentum in these names begins to fade. Fortunately, what history shows us is that once these relative performance, these mega-cap names start to subside, the broader market has historically held up just fine. That is what we’re trying to show you on the chart here.
These are returns after other periods where the largest S&P stocks were outside gainers. While the data on the left side of the page does show that returns were down to flat in the first few months following these previous peaks, luckily returns did start to broaden out a little bit and move further to the upside 6 and 12 months later as the S&P 500 recorded average gains of nearly 11% one year later. That’s shown by the dark blue bar on the right side of this page.
While the run-up we’ve seen in mega-cap names doesn’t typically spell disaster for the market, it does mean it does become a waiting game as we hope the rally in tech stocks broadens out to other industries.
The market up, what, 14%, 15% year to date a great number. We know every cycle has some similarities and every cycle has its own set of nuances. A narrow market as you suggest, seven companies really pushing the market higher is not uncommon, seen that before. Other companies in other sectors, some are flat, some are negative. Maybe we’re seeing this rolling slowdown, rolling recession.
The term rolling recession has been tossed around a lot. Despite the aggressive monetary tightening, the economy has so far avoided falling into a recession. Instead, we’ve experienced more of a rolling earnings recession, rolling through various industries at various times. You can look back at the tech sector last year, it was one of the worst performers. It fell 30% as the Fed tightened and earnings fell. Then moving forward to this year, it’s now turned in the top sector at more than 40%.
Turn things around on the flip side, the same thing can be said about other sectors like energy. It’s one of the few bright spots from last year its earnings soared on surging oil prices and then turn to this year and it’s one of the few sectors in the red. Now, the good news is we have already seen some signs of the rally starting to broaden out in June. We saw industries like cruise lines, airlines, home builders, start to finish as some of the best performers for the month.
This is an encouraging sign, but it is still a little too early to say, the rally has really sustainably broadened out with much confidence.
Remaining risks
Given the almost unanimous call for a pending recession earlier this year, it’s been a little surprising just how resilient the market has been, and how limited the amount of volatility that we’ve seen. To highlight this resiliency, we graphed the annual returns to the S&P of the funder, which are shown by the blue bars here, and the inter-year stock market declines, which are shown by the red dots.
There is a lot of data on this page, but we want to direct your focus just to the red box on the right side. There you’ll see that in just the first half of 2023, the equity market has now returned more than 16%, well ahead of longer-term S&P averages, which are down closer to 10%. Then on the flip side, the equity market is also well below the typical drawdown that we see. With the S&P only seeing a little 8% drawdown on the back of the SVB collapse. That’s compared to the typical drawdown, which is closer to 14%.
This year has already given us above-average returns and below-average volatility, we’re not looking to take on additional risk right now. That means taking back full circle, we still agree with our theme, waiting is the hardest part. We will continue to wait for some of the volatility that the market has been missing. Bigger drawdowns, they do happen. They are part of a normal and healthy market.
We’re always happy to take advantage of the investment opportunities that drawdowns particularly provide in order to better position our client portfolios.
Bond market taking bets
Short-term rates are higher than long-term rates. That’s the inversion we talked about. Both of these yields are way below where overnight rates are, and we think the Fed’s going even higher. The bond market has been way below Fed funds for a long time. It’s been very patient, and it’s been sending the signal for a very long time that the Fed is going to have to start easing in the not-too-distant future. Some folks worry that the bond market may be ahead of itself.
It’s hard to bet against the bond market and with the economic forecast we have, we do believe the Fed will start easing sometime next year. We think the bond market is going to be able to hang in here right about where we are now. The 10-year, around 4%, it’s actually a little higher than what’s on this graph. It probably has risen just enough to continue to be patient and wait for the Fed to get into easing mode next year..
We think that rates are probably at a pretty good peak-ish point, somewhere around here. Give or take, maybe 25 basis points. We might be in the range of the peak and rates. We shouldn’t be afraid of fixed income at this point in time. It’s hard to buy bonds 100 basis points below where your money market is. That’s always a tough trade to talk to anybody about, but it’s probably a reasonable time to start talking about biting the bullet, going down in yield, and starting to buy some protection against falling rates later.
What does this mean for you?
It means that we’re staying close to home. When someone who is charged with asset allocation talks about being close to home, that means that we’re neutral. That means that we’re staying right on top of our risk budget allocations. I think this is one of those times that it’s good to bring out canes as we’re talking about consumer consumption and what interest rates due to that.
The problem of why aren’t we trying to chase this rally in risk markets is, we think that likely the next stage is a downturn in economic activity, which would likely mean a downturn in risk assets. Trying to call that effectively is a very difficult game that the old joke is, if I could predict markets, then why would I need a job? The issue here is we don’t want to be anti-risk, but we don’t want to take on additional risk either. We stay neutral, and we wait until we see what’s going to unfold next.
I think when you start to see a change in the direction of Fed language, we’re definitely going to be looking to take on risk. The issue is right if you think about what brings value to a stock, the present value of earnings. As interest rates rise, that would normally mean that the farther out year earnings numbers have less value to that. The opposite of course is, what happens when rates fall? If we think that the long end of the curve is likely to be at its peak, that means that we’ll want to be buying stocks in the future, not today.
Just like markets tend to get over-exuberant and think that nothing bad can ever happen, once bad things start to happen, markets will tend to think that nothing good can ever happen again. We would much rather be buyers when Mr. Market is depressed than when he’s manic.
Economic summary of the first half of 2023
Let’s review our forecast. Even though we expect some type of slowdown or even a recession, we expect to see a 1.2% year-over-year real GDP growth won’t be bad.
We’re already working on our 2024 forecast, which would be higher than that. The unemployment rate we expect to climb. We talked about the unemployment rate where we expect things to slow down. Unfortunately, more layoffs across the economy, and slowly that unemployment rate will climb up to 4.3% by the end of the year. We gave you a review of what we expect to see from the federal reserve. Fed funds up to 575, which is two more hikes.
The next meeting will be at the end of July, and the next one is in September. By the end of the year, 575, and then a long pause as they allow the economy to digest higher interest rates. 10-year creeping up to 4%, we’re there now, we expect it to be in that trading range. It might creep up to four and a quarter, but that might be the peak there. We do expect positive rates to return, 7% to 14%, even though here we are up 14%.
You could see that volatility, you could see that slowdown, correction, and end the year somewhere in that range, which would be a pretty good year for all investors.
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