Through the Looking Glass
December 30, 2024
Dow: 42,573
This year was an exceptional year for most markets and while every year has surprises, several events played out very close to our predictions. We’ll reflect on our 2024 predictions in early January, but here are some thoughts to consider for 2025:
GLP-1’s – GLP-1 drugs have been a significant breakthrough for those struggling with obesity, offering substantial long-term health benefits to society. However, as the hype settles, we would expect the risks of these drugs to get more scrutiny. Some of the long-term risks may include pancreatitis, gastroparesis, thyroid cancer, bowel obstruction, vision loss, and depression.
Growth Pothole – There are already signs of slowing in the new home market, stemming from both high prices and high mortgage rates. If this flows through to other areas of the economy, we would expect to see GDP dip below 2% sometime in the first half of the year.
Growth Recovery – Following a downshift, we would expect GDP to recover smartly later next year. Real income growth should increase as inflation continues to slow, supporting consumer confidence. Tax and regulatory policy should swing more pro-business. We would expect GDP growth for the year to be above the high 2% range expected for 2024.
Stock Market – This market is very ripe for a correction after the run of the last two years. We would expect it to come early in the year, along with the growth slowdown scare. It is amazing how many strategists predict single digit up years for the stock market when they aren’t that common. We will call for another year of double digit returns. This is the money pick, as it has happened 60% of the time over the last 30 years.
China Fail – China is burdened with a great deal of nonperforming debt. The country may already be in a recession. Foreign investment in China has pulled back, and it will take time to work off the bad debt overhang. Avoid investment in China.
Home Price Correction – Softness is already beginning to appear in housing turnover. New home sales have slowed and inventory is building. Home mortgages near 7% are a drag, and those should drift down during the year. National home prices may still increase in the low to mid-single digits in 2025, as the housing market is very localized. Cities that have had booms, like Denver, Austin, and Orlando, may see double digit corrections.
Private Debt Problems – We called for a correction here last year, and it did not happen. It is still a case of far too much money being pumped into an area with little oversight and a high fee structure, along with low liquidity and low transparency on prices. This is usually a recipe for eventual disaster. Retail products are available that are backed by illiquid loans. Distribution to retail usually means the end may be near.
Immigration Backlash – This is happening in the United States, and it will continue to play out in other major countries, including Canada, France, U.K., and Germany. The political upheaval currently experienced by these countries is mainly driven by immigration concerns, and multi-party countries are having difficulty forming governments. The natural result of immigration concerns will be the continued rise of Nationalist parties in many of these countries.
Inflation – Inflation should continue to drift lower, along with the Fed Funds rate and rates across the yield curve. This will also be supportive to the equity markets and smaller capitalization companies. We have seen in 2024 that the economy and markets can survive 3% inflation. Lower inflation should be a bonus.
Trump Agenda Slowed – Perhaps Congress’ greatest skill is blowing a lot of hot air while accomplishing nothing. Trump does enter with some momentum, so it will be interesting to see what he prioritizes in terms of legislation in the first six months of his administration. The margins are tight, so he will have to give ground in some places to push through his major initiatives. Congress is always focused on the next election, and since the party margins are slim, we may see coalitions developing between the most conservative Democrats and the most liberal Republicans.
Thank you for the opportunity to work with you and we wish you a healthy, happy and prosperous New Year!
Random Thought: “The music of your youth stays with you throughout your life.” – Dick Clark
Risk and Opportunity
December 4, 2024
Dow: 45,014
The election is in the rear view mirror and the market is at new highs — what should investors do? We have always been big proponents of staying within your risk range regardless of market levels or geopolitical conditions. All three finalists running for President this year (Biden, Harris, and Trump) were judged by a large minority of the voting populace to be unqualified. We were destined to end up with one of the three. The world did not end, and now we can move forward knowing the result of the election.
In times of stress and uncertainty, we think of the example of 9/11/2001 and are reminded of the resilience of the American spirit. More Americans died on that day than at Pearl Harbor or D-Day. This supreme tragedy took place five blocks from the New York Stock Exchange, what many think is the heart of American capitalism. Nevertheless, it only took one month for the S&P 500 Index to recover to its September 10, 2001 closing level.
We believe that one of the keys to long-term investment success is to limit short-term emotional reactions. This is always difficult to do in the heat of the moment. We have found that the best way to resist the short-term urge to overreact is to think about your risk range, or tolerance level, before your emotions are tested. What range of stock allocations am I comfortable with? Will I have regret if my allocation is lower? Will I be able to sleep if my allocation is higher? Sometimes getting to the right risk range is a product of trial and error. It also changes throughout our lives, based not just on our age but also on our investment and life experiences.
There may be some who are feeling despair because of election results while others are elated. Some may feel elation because of their technology investments. Others may feel despair or regret because of their investments outside of the tech sector. All of our Strategies focus on finding investments that can be successful in various market cycles and such investments are always out there. Some market periods are harder than others, but with skill, diligence and patience, the odds of success increase over time. We are optimistic as we look for companies and investments that can execute their plans in most markets.
Because of the current events in the Ukraine and the Middle East, we are reminded that the world is a dangerous place and we have to be a force for good in the world. A large part of what is called the American spirit is evidenced in the success of American businesses and capital markets. We have a chance to benefit from these markets, both as investors and customers.
As we draw near to the end of 2024, we wish all a safe and joyous holiday season.
Random Thought: “There’s nothing you can do in the interest of being above average that does not expose you to the risk of being below average.” – Howard Marks
Pay Attention
August 29, 2024
Dow: 41,335
We are talking to Jerome Powell, not our readers and friends.
For a good number of months, and a good number of FOMC meetings, it has been all about inflation, inflation, inflation, and very little about the other part of the mandate for the Federal Reserve, maximum employment. The Federal Reserve was right to focus on inflation, and slay that dragon, before turning their attention to other matters. Inflation has finally begun another leg downward after bouncing around the low 3% level for most of this year. Based on the readings for the last few months, it should continue to trend towards 2%.
Hopefully this has given the Fed the ability to focus on the rest of the economy and not just inflation. We think they are now paying attention to unemployment, wage growth, commercial real estate values, productivity, and industrial output. This should make it easier for the Fed to cut rates more quickly in response to any economic weakness if inflation concerns are in their rear-view mirror. The new normal expectation for rate cuts is at least one per meeting for the foreseeable future. We feel comforted that both the stock and bond markets have those expectations as a backdrop. All in all, we think this makes it less likely that the Fed will miss early signs of a slowdown because they are too focused on the 2% inflation goal.
Both unit labor costs and average hourly earnings have been trending downward; the belief that employees would demand that employers compensate them for past inflation losses seems to have passed. Overall GDP growth has been running at a strong 3%. All of these are good signs so far, with inflation moving lower while the economy is still showing strong growth. Our concern is that Fed policy operates with a lag. We hope it is not the case, but they may find that they kept rates too high for too long, even as they begin cuts. Our concerns will ease if the economy stays resilient through the Fall as the Fed begins to cut rates.
Fixed income returns have bounced to very attractive levels as interest rates have begun to fall across the curve in anticipation of Fed rate cuts. After rising through the first four months of the year, rates have moved lower and are now below where they stood at the end of 2023. This move should help provide a tailwind for the economy and the bond market, and slightly eases our concerns about valuation levels in equities.
As we have emphasized in many client meetings, the S&P 500 Index is now much more of a growth stock index because tech stocks occupy the largest six positions in the index and make up almost 30% of the total market value of the index. Growth stocks are far more sensitive to changes in the expected trajectory of their growth or earnings since future earnings account for a large part of their valuation. When price/earnings ratios are high, as they are now, there is little patience for companies that don’t beat their earnings and revenue targets. Even though earnings reports have been above expectations for the second quarter, and the stock market is near all-time highs, we would not be surprised if the market moved sideways for a while.
This is not to say that equity allocations should not be maintained, as we haven’t found the person who can predict future moves. But certainly, expectations for future earnings have continued to increase, and the valuation levels on those future earnings (P/E ratios) have also increased. Even if the market moves sideways, it gives time for future earnings growth to bring the valuation level on the market down. That sets up a future move upward.
Random Thought: “Your time is limited, so don’t waste it living someone else’s life” -Steve Jobs
Good News Bad News
June 26, 2024
Dow: 39,128
Let’s just start by postulating that the stock market is not cheap, as valued by price to earnings. Markets that are at all-time highs never are, and markets normally get to new highs by having price gains outpace earnings gains. The title of this Viewpoint might lead you to believe that we are going to equivocate, an unpleasant habit of many market prognosticators, which ends up offering no help to the investor. The goal is to offer insight as to what factors are most important to the markets right now and how they might influence future market returns.
Earnings are one of the most important factors in moving the markets. It is not their absolute level or rate of growth that moves markets, but their levels and rate of change relative to consensus expectations. The consensus does not always end up being predictive of actual results. Our portfolio managers can be most positively impactful to portfolios when their opinions differ from the consensus and they are correct.
First quarter earnings reports provided the largest magnitude of positive surprises in over two years. These reports came out in late April and early May, during a time when the market was in a sideways consolidation following a 23% gain in the previous two quarters. The slight market downturn of about 5% in April was no doubt softened by the strong earnings reports relative to expectations. As these reports have been digested, the equity market has moved on to new all-time highs.
Let us restate that the market never looks cheap when it is at all-time highs, and it gets there by having some future potential gains pulled forward. The bar only gets higher for investable companies. One factor that makes us optimistic is that the rate of inflation has moved to a rate that is below the rate of income growth. Buying power is increasing, and employees should expect to recover most of what they lost to inflation.
Asset prices should also provide a boost to consumer sentiment, even though they also increase inequality. Over the last five years, the S&P 500 is up 15% annually, and home prices across the nation are up about 50% in total. This should continue to provide a sentiment boost to spending. For those that have owned their current home for a number of years, it also provides a large spending reservoir that can be tapped through home equity loans.
Although it is only at 4%, the unemployment rate is at its highest level since early 2022. An unemployment rate that moves up slightly from historic lows can actually be a good thing for the economy because it helps reduce the scarcity and cost of labor. It also typically represents people reentering the labor force and looking for work – a sign of economic optimism.
As inflation continues to stabilize or move lower in fits and starts, and concurrent economic indicators do not continue to strengthen, pressure increases on the Fed to begin to reduce rates. Market interest rates have stabilized or drifted lower this quarter, beginning to anticipate Fed rate reductions. This has reversed the negative returns that most bond investors experienced in the first quarter and offers bond investors a wonderful opportunity to earn attractive returns well above inflation. Money market rates have likely peaked, so we see value in extending maturities to lock-in higher yields longer.
The good news is that the economy has remained relatively strong despite higher interest rates and somewhat stubborn inflation. The bad news is that growth may be plateauing or slowing, and the lagged monetary effects of the Fed tightening may be in their early stages. The best news may again be the resiliency of the American economic machine. American innovation leads the world, and the current advances taking place could mark a continuation of the current prosperous era.
Random Thought: “The sun illuminates the world, knowledge illuminates a man.” -Mongolian proverb
The 12 Predictions of 2024
December 21, 2023
Dow: 37,404
Loosely modeled on the 12 days of Christmas.
The labor market will remain strong.
Real wage growth will accelerate.
Household wealth will continue to grow at a healthy clip.
Interest rates will continue to fall.
Inflation will be below 2% in 2024.
Private credit will be a problem.
FOMO
You will hear less about Artificial Intelligence.
GLP-1 will be the AI of 2024.
The stock market will broaden in 2024.
The S&P 500 will gain more than 10% in 2024.
Either Biden or Trump will not make it to the general election.
Everyone at Dana sends their best wishes for a healthy, happy, peaceful, and prosperous 2024.
Thankfulness
November 28, 2023
Dow: 35,417
It should not be cliché to say that we have much to be thankful for. We live in the democracy that has led the world for most of the past one hundred years. Our economy has continued to thrive on innovation. All of our largest technology companies were founded in the last fifty years; three of them have been around less than 25 years. They have been a key to the continued growth and prosperity in this country and around the world, and are supported by thousands of smaller companies, many of them also entrepreneurial success stories. There are many investment opportunities outside of the largest tech companies, as valuations outside of tech are currently below average, and the economy is continuing to expand.
Regarding the economy and markets, we are most thankful that the economy has endured the Fed rate hiking cycle and seems to have thrived in spite of the flurry of rate increases. Real GDP rose 5.2% in the third quarter, the strongest quarter of growth since 2014, aside from the post-Covid bounce. We have also experienced a productivity bump, with real GDP expanding more than 7% since the end of 2019, while unemployment has only increased 1.5%. This productivity increase is positive and has helped the economy deal with the bump in inflation. The S&P 500 Index has almost fully recovered from its recent July-October correction. The landscape looks very different today from the beginning of the year when the end was not in sight for rate increases, trailing inflation was still above 6%, and earnings declines were widely expected.
Unemployment is going up for the right reasons, as more people join the labor force. The elasticity of labor supply will help mitigate fears of a resurgence of inflation driven by demand increases and a more limited supply of labor. This is one case where unemployment increases due to growth in the labor force are a good thing as long as overall job growth continues to expand, and it has.
While the rebound in stocks can be attributed to the end of rate increases and the resilience of the economy, we can also be thankful for the recent decline in longer term interest rates. Over the last five weeks, longer rates have declined about 70 basis points, offering some relief from impending borrowing cost increases. Even the red hot housing market shows signs of leveling off, as existing home sales have dropped significantly.
With employment growth remaining strong, consumer confidence should also remain strong, or even strengthen, into 2024. Much of our economy is driven by confidence. It drives financial transactions of all types, including driving individuals and companies to spend and invest. If we do not experience disinflation next year, we should enter an environment where real wage growth should strengthen and families will recoup some of the purchasing power they lost in 2021 and 2022.
We are also thankful to announce that three of our investment strategies were named to PSN’s Top Guns List of best performing separate accounts, managed accounts, and managed ETF strategies for 3Q 2023.
We are proud of these three equity strategies’ notable 3Q rankings and are already hard at work with the goal of achieving similarly strong rankings and results for our investors in 4Q. Published quarterly by Zephyr, the highly anticipated PSN Top Guns list is one of the most important references for investors and asset managers. Rankings are tabulated for thousands of strategies across 75 peer groups subdivided by increasingly rigorous screens and reported in ascending classes from 1-6 stars.
At Dana, we are thankful for a challenging work experience that supports personal growth, excellent colleagues with which to share our career journey, and clients that we are fortunate to serve and with whom we have built beneficial and lasting relationships
Random Thought: “Showing gratitude is one of the simplest yet most powerful things humans can do for each other.” – Randy Pausch, author of The Last Lecture
[2-Star Category:] had one of the top ten returns for the one-year period in their respective strategy.
[3-Star Category:] had one of the top ten returns for the three-year period in their respective strategy.
[5-Star Category:] had an r-squared of 0.80 or greater relative to the style benchmark for the recent five-year period. Moreover, the strategy’s returns exceeded the style benchmark for the three latest three-year rolling periods. Products are then selected which have a standard deviation for the five-year period equal or less than the median standard deviation for the peer group. The top ten returns for the latest three-year period then become the 5 Star Top Guns.
The Pause That Refreshes
September 27, 2023
Dow: 33,550
We all know market corrections are normal. Look at a long-term chart of almost any stock or market index – they invariably look like some sort of a serrated knife held at an upwardly sloping angle. The ones with problems look like a knife held at a downwardly sloping angle. On many, the serrations look more severe and haphazard than normal. If the slope trends upward over time, things are going well and the company is executing its business plan properly. If the long-term trend is down, obviously there are business problems that need to be fixed.
The S&P 500 Index is down more than 5% since July 31st. The Index gained almost 20% in the prior four and one half months. Is this an ominous sign of problems to come? There is no indication that storm clouds are on the horizon. The slowdown in earnings appears to have turned, and the S&P 500 Index companies should show meaningful earnings growth for the year.
Nevertheless, there are hurdles for the markets to overcome. Treasury yields are at or near multi-decade highs, consumer purchasing power is still feeling the pinch from past inflation, and housing costs have increased, both in terms of housing prices and borrowing costs, a double whammy.
The current key driver of worry in the markets is interest rates, especially on the longer end of the curve. The ten year treasury has moved up to 4.50%, a sixteen year high. Paradoxically, treasury yields are rising while inflation is falling. Annualized inflation has fallen to below 4% from a high of 9% last summer, and it should continue to trend towards 3% or lower over the next few quarters. Higher treasury yields push borrowing costs higher across the economy. Credit card rates trend up, mortgage rates increase, and borrowing costs for companies go higher. This creates a drag on the economy, and the fact that it is happening now, more than a year after the Federal Reserve began increasing the Fed Funds rate, is evidence of the lagged effect of monetary policy. Part of the problem with Fed policy is they do not know if they have done too little, or too much, for months or years after they have made a change in monetary policy.
Government spending has played a part in this bout of inflation. The Federal deficit, or the amount spent minus total government receipts, will exceed eight trillion dollars for the past three fiscal years. When the real rate of interest is negative, i.e., treasury borrowing costs are below the rate of inflation, borrowing is a form of free lunch for the government. That has now changed as the rate of inflation moves below the cost of borrowing for the government. Decisions in Washington will be much more difficult without the low borrowing cost tailwind. We are not optimistic that most of the representatives in Washington are willing, or qualified, to make these difficult decisions. Politicians are well known for taking the path of least resistance. Federal borrowing costs will now be a drag on the economy that is greater than the stimulus benefit of Federal spending.
Who benefits from positive real interest rates? Bond investors. Bond investors will now receive an income return on their investment that is higher than the rate of inflation. As longer rates move up, there is less of an income disadvantage for choosing to lock in current yields for a longer period of time. Our portfolio managers are taking advantage of these opportunities in the market every day in every one of our fixed income strategies. For example, high-quality, short-term bonds now offer yields near 6%, the highest returns since 2007. Municipal bonds also offer excellent value for savers or entities in higher tax brackets.
Back to the stock market, it is difficult to see this move downward in equities as anything other than a garden variety market correction. Companies have proven they have varying degrees of pricing power, revenues have been resilient, and larger numbers of participants are rejoining the labor market. Earnings have rebounded, and the layoffs in the tech sector of the market have seemed to run their course. We will continue to be vigilant regarding the effect of higher interest rates. A Fed near the end of its tightening cycle and inflation trending lower are two key positives that we expect to provide support to equity prices.
Random Thought: “Theory is when you know everything and nothing works; practice is when everything works and nobody knows why.” – Albert Einstein
Almost There
August 3, 2023
Dow: 35,216
Are we there yet? Ok maybe we are there. The “there” being the end of the Federal Reserve interest rate increases. Inflation is coming down, the economy is still growing, unemployment has not increased meaningfully, and the consumer may still have purchasing power to spare. So, what is the next challenge for the market? There are always possible threats on the horizon, but here are a few of the current headwinds and tailwinds.
Jerome Powell overdoing the rate increases has been our primary concern, as most of you know from past Viewpoints. The Fed Funds rate has been increased 10 times, for a total of five percentage points, in the last 15 months. The speed and magnitude of the increases has slowed, but that has been no less worrisome, as monetary policy works with a lag. On the plus side, S&P 500 corporate earnings fell during 2022 but are showing a recovery in the first two quarters of 2023. The unemployment rate has remained below 4% for the last 17 months, even as rates have increased significantly. This certainly demonstrates economic resiliency.
We must chuckle as Jerome Powell takes credit for lowering inflation as he as much as told us all that the economy and the job market had to be slowed in order to conquer inflation. Yet inflation has slowed while the job market has remained robust and economic growth has turned positive. Better update your rulebook, Jerome.
Although the news has been good so far, we must keep an eye on economic indicators, as rate increases affect the economy over time. So far, some slight slowing in employment cost indexes and payroll growth should give the Fed some pause, and manufacturing has definitely slowed this year. We need some slowing to rein in the Fed, but not so much that it slows profit growth and dampens consumer confidence. So far, the economy seems to be settling in that Goldilocks sweet spot.
The Goldilocks soft landing scenario is reflected in earnings. Company reports beat analyst estimates by a fair margin in the first quarter and are doing the same in the second quarter. This is driving the market. You can almost feel the bears and the underinvested participants being pulled in and forced to buy over the last few weeks. This is what drives bull markets. Prices go up faster than earnings as price to earnings ratios expand. A number of popular bearish strategists are being forced to concede to the market’s strength. Many of these analysts had a following because they were bearish last year and correct, but the perma bear approach doesn’t work with a dynamic economy that is continually evolving and adapting.
Once the market moved up 20% off the October 2022 low, the S&P 500 Index was officially declared to be in a bull market. The average increase from that point, before another bear market, is 100%. Sure, there can be corrections or unforeseen events that can drive a new bear market, but another 100% gain without a 20% pullback is the historical baseline.
The bond market is also behaving as if economic growth has legs. The ten-year Treasury yield has begun to move up, seemingly signaling decreased chances of a recession near term. Corporate yield spreads to Treasuries have also stayed in a narrow range, reflecting the perception that companies can afford to repay their debt, even if they have to borrow at higher current rates. It certainly is rewarding to invest client bond allocations in quality securities yielding 5-6% now that rates are higher.
So, if the Fed is able to complete this rate increase cycle without pushing the economy into recession, we are willing to concede mission accomplished, and we would be happy to let another actor other than Jerome Powell take center stage. Maybe someone will step-up and address the concerns raised by Fitch in their latest downgrade of US debt.
Random Thought: “I did not succeed in life by intelligence. I succeeded because I have a long attention span” – Charlie Munger, Vice Chairman of Berkshire Hathaway
Stuck in the Middle With You
May 30, 2023
Dow: 33,042
We refer to the title of a 1973 hit song by Stealers Wheel. This has to be the way Jerome Powell, or any Federal Reserve Chair, feels at turning points in the rate cycle. “Clowns to the left of me, jokers to my right, here I am, stuck in the middle with you.” Catchy lyrics; and at the beginning and ends of rate cycles, it is usually most difficult to build consensus. Powell is truly stuck in the middle, or he has to stake out a position that becomes the middle in order to develop consensus.
For the last few weeks, it felt as if a pause was the clear consensus, but the equity market has moved to new highs and economic reports have been somewhat resilient. There may well be a pause at the June meeting, but markets are now expecting another increase at the late July meeting. We hope this isn’t so as the M2 measure of money supply is shrinking at an unprecedented rate. Supply and demand governs many market relationships and is a key source of market discipline. From 2020 through 2022, the economy was flooded with cash through many government programs designed to support the economy. These programs worked, but there was no return to normal. Many stimulative government programs continued into 2023. The money supply ballooned during this period, and inflation followed. We don’t disagree with the implementation of these large stimulus programs, but it now seems unusual to believe that the inflation would be temporary if the stimulus that caused it isn’t promptly removed from the system when the economic danger passes.
As we have pointed out before, over the next seven weeks, we will get two more inflation reports that should move the trailing year inflation numbers into the mid 3% range. If the Fed truly believes that their policy operates with a lag, they should pause. Inflation rates dropped to the mid 3’s in the third quarter of 2022, and they have maintained those levels as the Fed has continued to increase their policy rate. The economy has remained resilient as the Fed has raised rates and moved nearer the end of their tightening cycle. Last year we talked about this being our best-case scenario, and so far, it has played out.
Although the Fed policy rate has increased three times this year, Treasury yields at two-year maturities and beyond have barely budged, resulting in positive year-to-date returns for fixed income investors. Long rates have moved off their lows, implying a reduced risk of an imminent recession. As first quarter earnings season has concluded, fear of an imminent downturn in profits has also receded, and total returns of most equity indices are soundly higher. While the S&P 500 Index is up over 10% for the year, 100% of the return can be attributed to just eight of the largest stocks with only 28% of stocks outperforming the Index return.
Stuck in the middle with you is also an apt description of the current relationship between the Speaker of the House Kevin McCarthy and President Biden. They have spent a good deal of time together over the last few weeks – how can that not be a good thing? Most of the reporting on the debt ceiling has been incorrect and borderline dangerous. Treasury Secretary Janet Yellen recently said that in the event the debt ceiling isn’t raised, “We have to default on some obligation, whether it’s Treasuries or payments to Social Security recipients” – this is irresponsible. A late payment made by the government to anyone or any entity other than a debtholder is not a default, it is a late payment. If a company pays a supplier late, it is not a default. Government officials know that interest and principal on Treasury debt will be paid first, above all else, but stating that does not help them increase their political leverage.
Sad Random Fact: In the fiscal year ended September 30, 2022, the deficit was $1.4 trillion dollars, or approximately $160 million per hour.
Show Me the Money
April 11, 2023
Dow: 33,684
The depositors in many regional banks seemed to echo Cuba Gooding Jr’s famous line from the movie Jerry Maguire, “Show me the money.” The bankers’ response seemed to echo Jimmy Stewart’s from It’s a Wonderful Life, “The money’s not here, it’s in Joe’s house” and other income producing investments. A great example of how a bank is a collection of assets and liabilities, loans, and deposits. That little thing called leverage also usually plays a role in fast moving liquidity crises. No bank can sustain a short-term demand for the return of a majority of its deposits – a bank run. It is the job of the banks individually, and the government and regulators as a whole, to ensure that there is confidence in the system. The failure lies both with the management of the banks, and with the regulators and government officials tasked with both limiting the risk that there will be a bank run and reacting appropriately to stop it when it happens.
The stock market is up since its recent low of March 13, which was higher than its December low, which was higher than its October low. So far, markets and the economy are holding up in the battle against the Fed’s effort to slow the economy and raise unemployment. The battle is not won. There are unforeseen fragilities in the system, as the struggles in the banking system demonstrated last month. First quarter earnings will provide a barometer of how the economy is holding up through the most recent rate increases. We expect that the news will be largely positive. Companies have discovered a new focus on controlling costs and focusing on profit. Consumers are largely optimistic as they have seen inflation roll over in the second half of 2022. The immediate shock of higher mortgage rates is working its way through the housing market. Supply chain issues have continued to abate, which helps businesses plan better and optimize their operations.
The Treasury market has shown significantly increased volatility as banks became more stressed. Even as the Fed raised rates at their March meeting by 25 basis points, Treasury yields fell across the yield curve. The two-year Treasury fell 80 basis points in March, and the ten-year Treasury fell 45 basis points. Instead of expecting Fed Funds above 5% by year end, the market now expects rates to be cut at least three times by year end.
There have been three Fed rate hiking cycles since the late 1990’s, and we are now in the fourth. In every case where the two-year Treasury yield dropped below the Fed Funds rate, the next Fed rate move has been a cut. The two-year Treasury dropped below the Fed Funds rate in June of 2000, and the Fed cut rates six months later. It happened again in July of 2006, and the Fed did not cut rates until 15 months later. The Great Financial Crisis followed, and the S&P 500 Index did not bottom until eighteen months after the first rate cut. In the third instance, the two-year Treasury dropped below Fed Funds in March of 2019, and the Fed cut rates four months later. The ten-year Treasury yield moving below the three-month Bill yield may be an even better indicator of imminent Fed rate cuts, and that spread has been negative for five months.
Some indicators of economic activity are slowing without an abrupt reversal, and the labor market seems to be softening ever so slightly. These are both excellent signs because they demonstrate that the economy may remain healthy as we approach the end of the Fed tightening cycle – the proverbial ”soft landing.” Corporate earnings and company outlooks will be insightful as they begin to be reported for the first quarter.
Market returns have been respectable in the first quarter in both the stock and bond markets, representing a partial recovery from 2022 returns and recognition that we may navigate this Fed tightening cycle without material damage to the economy. If we had to pick one economic indicator to use to navigate the markets, it would be the unemployment rate. As long as we do not see a material rise in unemployment, the economy should be able to navigate higher short-term rates without a slowdown.
There seems to be a significant amount of pessimism present among market participants, evidenced by declining long-term Treasury rates and expected Fed rate cuts in the back half of the year. Higher than normal pessimism is usually accompanied by market opportunities, and we seek to take advantage of these opportunities.
Random thought: FDIC Insurance historically had limits, until it recently seemingly didn’t:
