Life is like an ever-shifting kaleidoscope – a slight change, and all patterns alter. – Sharon Salzberg
The headlines of the various stories in the July 30th Wall Street Journal seemed to leave little doubt as to which direction this current version of the economic train was heading. “Recession or Not, the Recovery Has Ended.” “Are We in a Recession Now?” “Jobless Claims Hold Near Highest Level of the Year.” “Inflation Hits Fresh Four-Decade High.” “Heard on the Street: Recession Isn’t Necessary for Investors to Feel Bad.” With that by way of counsel another headline “S&P 500 Posts Best Month Since 2020 as Stocks Rally” seemed as out of place as a rose in a briar patch.
Certainly investors who, for much of the year, were long on suffering even as they were wishing they had been short on stocks, were grateful for the respite in their experience of a sea of red as the S&P 500 put in an 8% rise for July and 12.8% since the, don’t we hope, lows for the year on June 16th which, perhaps not coincidentally, was the day after a meeting of the Fed’s Open Market Committee where they voted to raise interest rates .75%. Curiously though, while with the one hand the Fed was raising the Fed Funds Rate, the interest rates set by the other hand, that of the financial markets, are declining. The high for the 2 Year Treasury Rate was 3.45% on June 14th. It currently rests at 2.85%. The 10 Year Treasury Rate peaked that same date at 3.49% and has since fallen to 2.68%. The financial markets, which, on June 14th, were predicting 90- day interest rates to reach 4.25% by year end now expect that rate to rise to just 3.50% at the beginning of December and then to begin to decline. In other words, the financial markets are predicting the Fed will be lowering interest rates before the end of the year. So, pray tell, what is going on here?
Could it be that the explanation is to be found in the news story headlines in the first paragraph of this commentary? The Fed is raising interest rates and those higher rates are threatening to, if not yet actually having already done so, push the economy into the purgatory of recession. Possibly, but not likely, as evidenced by a number of counterfactuals. Why is the stock market rallying? And not just that it is but how it is. The two best performing industries of the S&P 500 are, since June 16th through July 27th, Automobile Manufacturers +26.8% and Homebuilders +25.2%. And of the four sectors of the S&P 500 up the most in the month of July three of the four, Real Estate, Consumer Discretionary and Industrials (the fourth is, not surprisingly, Technology) are those sectors that tend to rally at the BEGINNING of an economic recovery. So truly we do have a collision of narratives here with headlines trumpeting recession and the stock market rally saying recovery.
Dare we say that it may be Goldilocks? The economy may be slowing enough to allow the Fed to hit the pause button on further interest rate increases after another likely .50% on September 21st that may allow an avoidance of notable damage to corporate earnings. Possibly there is another factor at work here as well. Inflation comes in two “flavors,” demand-pull and supply-push. The former is the classic “too much money chasing too few goods.” The latter, one less frequently commented upon, is a lack of supply leading to higher prices. The Fed can certainly reduce economic demand by raising rates sufficiently to push the economy into recession, but interest rate increases don’t do a thing to increase the output of gasoline or beef. Help though may be on the way. Producer Prices measure the cost of economic inputs, for instance the price of lumber as a cost of constructing a new house. The prices of Core Crude Goods, a rate excluding food and energy prices, is up 7.1% year over year and has been declining. The Headline rate, which does include those items, is up an eye watering 58% year over year but since June 1st energy and agriculture prices have fallen 7.45% and 10.24% respectively. So maybe it’s getting close to the time for the Fed to declare victory over inflation and to redirect its focus upon supporting economic growth rates.
If indeed Goldilocks is about to be served her meal just the way she likes it the good times for investors may be much closer to their beginning than their end. The S&P 500 is still negative 12.6% for the year, certainly a much better number than the low in mid- June of -22.5%, but corporate earnings are actually up for the year so the decline is solely attributable to a falling valuation level which is down to 17.2 times earnings, close to its historical average of 16. The story for Mid Cap and Small Cap stocks is a distinctly different one with their trading at 12.7 and 12.4 times their respective earnings. Also worth noting is that the US economy may, for the near future, be experiencing a rate of growth exceeding that of most of the rest of the world so, with their earnings being almost solely dependent upon domestic demand, which may be yet another characteristic in their favor.
So, some good news at last. For 60/40 portfolios the equity portion returned a cool 8% with Foreign’s 5% pulling that figure down below that of the S&P 500 but with small cap’s +9.60% partially offsetting it. Fixed Income contributed a modest +.50% aided by the month’s interest rate declines to overall portfolio returns of 4.5% reducing the negative year to date figure to -10.7%. Here is hoping for a hot August!
Mark H. Tekamp, August 1, 2022