Time is slow, time is fast. It never stops, but it always lasts.
– Anxhelo Llangozi, A Poem About Time
The last day of October, Halloween, “spooked” investors in big cap tech stocks with The Wall Street Journal headlining its coverage of that day’s market action, “Big Tech Earnings Drag Down Stocks.” The first sentence of the accompanying story reading, “Disappointing quarterly results from big technology companies pushed stocks lower Thursday, sending the S&P 500 to its first monthly loss since April.” Year to date “The Mag 7” have been carrying the rest of that index on their back but, after having cheered the spending of many billions of dollars pursuing the magic of AI, investors are showing signs of becoming nervous about how soon the promise will become reality. However, the experience of the day was at variance with that of October’s -0.91% return of “the 500,” being materially better than that of the average stock in the index declining 1.63%, small cap stocks –2.64%, and foreign developed market’s -4.36%.
The financial markets which are the canvas upon which investors paint their perception of the future have certainly undergone a dramatic change in two years’ time. As 2022 wound its way to its end, investors were looking at near 20% losses in both their equity and fixed income investments. The inverted yield curve was a signpost pointing towards recession, falling earnings and even lower stock prices with expectations of persistent and elevated levels of inflation, and a Federal Reserve keeping interest rates elevated as it struggled to put the inflation genie back in its bottle. Today, that canvas is painted with colors of a distinctly different hue. Inflation has declined to close to the Federal Reserve’s target but may be poised to begin to rise. The economy may have slowed a tad, but its rate of growth too is possibly preparing to accelerate. The Fed’s ½% rate-cuts in September were likely excessive and additional rate cuts may not be warranted. If the stock market is not inexpensive, it is supported by next year’s 12% expected increase in earnings on a year-over-year basis.
Charts detailing US economic growth rates often indicate the times of economic recession with shadings of gray. Overlaying a history of the level of the Federal Reserve’s Fed Funds Rate to that chart and backdating it to the onset of the 21st century, it is difficult to avoid the observation of a correlation. Every economic recession, and there have been three this century to date, has occurred after a time in which the Federal Reserve concluded a cycle of raising interest rates. Each cycle of rate increases resulted in a recession and an equity bear market. Each recession and resulting equity bear market were preceded by a rate tightening cycle. We’ll discard the pandemic of 2020 as a unique event, but it may be a useful exercise for investors in equities to ask themselves if this time will be different and, if so, why this time will prove itself to be the exception.
Interest rates are the cost of borrowing, and it seems to make a certain amount of sense that the greater the amount of debt and the larger the extent of interest rate increases, the greater the impact of those interest rate increases on the underlying economy. From March 30, 1999, to May 15, 2000, the Fed raised its discount rate from 4.75% to 6.50%. The market peaked on March 24, 2000, and subsequently declined by 49.15%. At year-end 1999, total debt in the US was 189% of GDP. From May 4, 2004, to June 29, 2006, the Fed increased the discount rate from 1.00% to 5.25%. The market peaked on October 9, 2007, and then declined by 56.77%. At year-end 2007, total debt in the US was 237% of GDP. From March 17, 2022, to July 26, 2023, the Fed raised the discount rate from 0.25% to 5.50%, with total rate increases of 5.25% exceeding the rate increases of 2004 to 2006 by 1%. The total debt of the US is now 261%.
As mentioned above, markets at the end of 2022 were “all in” on the prospects for an economic recession, but they have become increasingly comfortable adopting the view that “if it hasn’t happened yet, it’s because it isn’t going to.” However, it may be that a wager investors should exercise caution in making. Darker clouds may now be starting to come into view. The US economy, characterized by its very high levels of fiscal stimulus and the mirror image of a very large and growing federal budget deficit, has been a notable outlier in a world economy that, this year, is experiencing sequentially lower rates of growth. This is leading to rising market-based interest rates both in the US and globally, as well as a stronger US dollar. Foreign countries, with much of their debt valued in those same dollars and with much weaker economies, are responding by aggressively lowering interest rates set by their central banks, leading to a widening spread in their interest rates vis-à-vis those set by a still very cautious US Federal Reserve. The result is a negative feedback loop, creating an even stronger US dollar and applying increasing amounts of stress to an increasingly fragile global financial system.
With the lowering of our expectations for positive equity markets, we are adjusting the model portfolio of interest from 60% equity and 40% fixed income and cash to an equal weighting of 50% each. October created a 1.75 % negative return, leaving portfolio returns at +11.18% year-to-date. Equities returned -2.35%, with large-cap US equities down nearly 1%, but foreign markets returning -6%, and small-cap US equities at -3%. The 50% fixed income and cash returned -1.15%.
Mark H. Tekamp