Market Commentary | Q2 2023 Halftime Report


Sam Chaplin:

Hello. Hello everybody. Welcome to PFA’s Q2 halftime report, hotly anticipated. Hope everybody’s having a great summer so far as we’re headed into Memorial Day weekend. It’s nice weather come coming in, so hope everybody has some fun plans. My name is Sam Chaplin. I am joined by our chief investment officer, founder, fearless Leader, James Bradley. How are you?

James Bradley:

Hey everybody, how are you doing? Happy Memorial Day weekend. Hope we don’t crash the economy between the recording of this and when you have your second hotdog.

Sam Chaplin:

And we’re off, here we go. Coming up on the agenda, we got the economy, some highlights on the macro data side there, looking at performance of the markets and what’s going on, the factors impacting them, as well as our investment committee outlook as we’re looking forward here from the middle of the second quarter. Next up here is the slide I’ve used before, but it’s just provide some good context for what we’ll be talking about going forward and market’s still in a bit of limbo at the moment as we’re trying to strike this balance between economic growth and price stability. Very difficult thing to do, but it falls on the Fed to be able to do that. And the tool they use to do that is interest rates. And the key here is that they want to hike interest rates enough that it slows demand, bring inflation down, but not so much that it actually slows demand to the point that it puts us into recession.

So that is the balance trying to be struck here. A lot of debate on either side over the Fed’s not gone far enough, the Fed’s gone too far, and different outcomes would be very diverse based on which one of those scenarios is true. So, not a lot of conviction in the market right now. We’re still waiting for these interest rights to take hold and see what slowdown in the economy we do see, have seen some good news on the inflation side, so that is a plus. When we consolidate all this macro data down into the one chart here, you can see on the top we got the effective federal funds rates.

So that’s what the Fed has done so far. Initially dropping interest rates when the pandemic hit and then hiking again early last year. Looking at that second chart in the middle there you can see the path of inflation, and you’ll note that the Fed didn’t start hiking interest rates until we are almost near the peak in inflation and those interest rates take a while to work their way into the economy and we have seen inflation come down from peaking around 9% in July of last year down to about 5% now. And, some good news forthcoming that should be able to bring that number down further. All the while, economic growth has remained positive for the most part. We had those two slight down quarters, but since then, we’re back up to 1.1% growth in the first quarter. That’s compared to about 2% long-term average. So, not as fast as the economy typically grows, but still in positive territory. So that is good.

A couple other things to note here that don’t necessarily come through on the charts is that those lag effects from those interest rates can take something like 12 to 18 months before that interest rate hike really takes hold in the economy. So it’s not an immediate thing. The Fed hikes interest rates, that doesn’t mean everybody has to go out and immediately get financing and change the way they behave. Over time, people need to obtain financing, and as that happens, that’s when the economy starts to slow down a little bit. A lot of the stimulus measures and the cheap money that we had during the pandemic allowed people to have pretty healthy balance sheets. So they didn’t initially have to do a lot of borrowing, which has been able to help float the economy along so far. But over time, they will need to refinance at higher rates, which means that we’ll slow demand down.

The other thing to note here is that the consumer price index on the headline level at 4.93% doesn’t really tell the whole story. I will note that goods inflation has come down substantially, which is great because that’s where a lot of the initial inflation was. Things like housing and autos you can think of those are very interest rate sensitive. Interest rates go up, you’re going to be less likely to buy one of those things. However, on the services side it is less interest rate sensitive and inflation has remained pretty hot there. You can think, going out to get a haircut, you’re not going to say, “Oh, interest rates have gone up. I’m not getting a haircut today.” At least for those of you who like getting a haircut.

James Bradley:

I might say it.

Sam Chaplin:

Yeah. So, pretty good news overall. This is what we wanted to see. Consumer price index coming down, inflation coming down. Well, GDP remains positive, but we do still have a lot of those big interest red hikes that hit the middle of last year but have yet to fully take hold. So, a lot of debate over what effects that will have. So, good news so far. James is going to tell you a little bit more about the resilience we’ve seen in the economy. If last year somebody told you that interest rates the Fed was going to hike the 5% at this point pretty much across the board, everybody would’ve said, we’d be in recession by this point, but we’re not. And, a couple reasons here on the next slide.

James Bradley:

Yeah, you just brought up the fact that, no we’re not in a recession yet, at least not across the board. There’s arguments that there’s rolling recessions going on at certain places throughout the economy. But, as you mentioned, we’re still north of 1% G P growth. And gosh, if you had told me 5% jack up in interest rates over a relatively short period of time, that should put a pretty positive curve on the unemployment rate. That’s what it’s typically done in the past. But we see from this slide here, no such thing, it’s actually stayed low, and I would say, probably is pretty close to record low unemployment right now just off of 3.4%. All the while, the consumer has stayed in the game and that’s the lower line that we see on this chart with consumer U.S. retail sales holding their own, despite, like you say, a challenging environment that the Fed is giving us.

So why is this happening? First off, as far as the unemployment rate goes, there was a lot of slack that needed to be taken out of the system. So yeah, companies haven’t been hiring nearly so much, but they’re really hesitant to downsize this workforce that they’ve worked hard building over the past couple of years. So, we’re seeing a little bit of tech industry layoffs from here to there, but that seems to be more of a repositioning of some of the talents to places that ended up scooping up too much and they’re going over to places that still have the openings. It hasn’t accrued to a larger unemployment rate yet. In turn, from people still being employed, they’re still spending money. And that’s important when we look at the economy, because the consumer, depending upon who you talked to, is somewhere between 60 and 70% of U.S. gross domestic product, and U.S. economic activity.

So, this has kept growth going a bit during the year, but one of the potential downsides to it is for those who are starting to bank on the Fed loosening up down the road with lower interest rates, Sam and I will talk a little bit more about this at the end, but what operates against that argument because it really gives the Fed cover to remain a little bit tight on monetary policy, to keep rates a little bit higher for longer, just because they aren’t looking at something that gives them immediate pause when they look at the jobs market. Go to the next slide here and we’re looking at the way the stock market has performed this year. It’s been an interesting thing to look at. There was a broad-based rally and that started off in the first quarter, but then the market had to react to the Fed actually jacking up expectations for interest rates and that brought things down a little bit.

Then, the index itself seems to have recovered and that’s that teal line up on the top chart there. But, if you look at the line below it, that’s the line that represents the average movement of a stock in the S&P500. So the top line is the index itself, the bottom line is the average stock in the index, and the reason that those are different trajectories is because it’s what they call a market cap weighted index and that gives bigger movement potential to bigger companies that are part of the index. So, the S&P500’s made up of some really large companies and some huge mammoth companies. It’s been these huge mammoth companies, specifically big tech companies and that type of thing, that tends to be a little bit more sensitive to interest rates did grab onto the hope that rates would come down a little bit in the second part of this year and they got a lot better of a boost from that hope than the rest of the market.

So, if you’re a stock investor, picking stocks, don’t beat yourself up too badly if you didn’t keep up with the S&P500, because you really needed to have your money in a few specific stocks in the S&P500 during the course of the first part of the year. Last one that I’m going to go over here is this treasury yield curve. When you hear things about a “inverted yield curve,” that people talk about and quite often that’s looked at as a precursor of a recession, you’d be visualizing that on this chart. The lower part of the chart, the blue curve is what a yield curve typically looks like, and that’s over the past 10 years what the average yield curve has looked like. But if you look at the teal one, on the top, that’s what the current one looks like. It’s not bending in the same direction, it’s actually inverted, meaning that short-term rates are a good bit higher than long-term rates.

And if you go out shopping for CDs, you’ll see this. If you go out shopping for bonds, you’ll see this dynamic where there’s higher interest rates being given to things on the 12, 18, 24 month side than to things that are longer out there, which is driving a lot of people to load up on those higher interest rates. And we always want to make sure that they’re using some caution when they do that. And we’re certainly using caution when we do that. We don’t want to load up entirely on those higher short-term interest rates, because if and when rates normalize, you’re not going to be able to reinvest that money in the short-term at the same rate. So, it’s locking some in and taking advantage of what we call some duration risk or duration exposure in your portfolio might make a lot of sense. And we’re going to turn it back over to Sam to talk about some of the risks that we’re facing.

Sam Chaplin:

Thank you, James. Yeah, fixed income finally getting a little bit more exciting. We’re talking about it, it’s been a good time. So, looking at some key risks and I would also say opportunities in the market, risk can manifest upwards or downwards. So, don’t always think about the downside. The first one we’re looking at here is the debt ceiling negotiations going on in the U.S. government. Most of you are likely familiar with this. It’s been a big deal in the headlines. So far, the market’s been pretty complacent with it so far. I mean, we’ve had these negotiations 78 times and raised the debt 78 times. So, what is the probability that this is the time that we don’t and we default, type of thing.

So, the markets are a little bit complacent there and I think that might even be leading the politicians to be a little bit complacent, because when politicians are negotiating over these things and nobody’s really sure how this impacts them on the ground, at least the average American, and it’s an ethereal thing and it’s just politicians being politicians is what it sounds like. But we do think this could create some volatility in the market in the near term. We don’t think it’s going to be some type of catastrophic event. But, the ironic part of this is that it might take the market getting a little upset to give these politicians the push they need to get a deal done. So I wouldn’t be surprised if as time goes on, over these next couple weeks, that the market starts to get a little more volatile, starts to send a message to these politicians saying, “Hey, this is getting real. Now my retirement count is falling. So, you better do something about this.” And, I think, so far the market being so complacent has given politicians a little more leeway than they probably deserve. So that’s first.

Second is systemic events as risks, and that always happens during a rising interest rate environment. There’s a saying… A couple good sayings. One is that, “Low interest rates hide a lot of sins.” If you can go out and get money for nearly free, then you don’t need to have a very resilient business model. You don’t need to be doing a great job at risk management. But once those interest rates go up, those sins start to get exposed. And we saw some of that with the banking… I don’t want to call it a banking crisis. Everybody’s struggling with what they call this, because banking crisis brings up some PTSD for a lot of people. I think, my favorite is the banking kerfuffle. Let me go with that.

So as the interest rates have come back up and exposed at some of those regional banks and do a very good job of managing their interest rate risk and have had a lot of fallout, so that seems to be contained at the moment. The Fed was able to step in, ring fence it. A lot of the bigger banks that are much more systemically important are actually getting stronger because of this. And, we can debate about whether that’s a good or a bad thing, but it’s definitely a strong get stronger environment.

And then… Let’s see. But you never know where these systemic risks are going to pop up. There’s concerns about commercial real estate market which has now been hurting because of people not working in the offices and that type of thing. So as interest rates go up, it can start to expose those things. I think there’s a Warren Buffet quote that says, “Only when the time goes out, you learn who’s up and swimming naked.” And that’s what we’re dealing with here. And again, the longer the interest rates stay high, the more probability of these events, because more time goes on, the more people need to refinance. And, some of them can, whether their refinancing, and some of them can’t. And we’ll talk in a moment about the differences between what the market thinks interest rates are going to do and what the Fed thinks interest rates are going to do, which is a hotly debated topic.

And last I just got geopolitical risks on here. And that’s one that’s likely longer-term. The market tends to be, again, not too upset with geopolitical risk until they start to affect the actual market case, if it starts to affect trade and starts to affect currencies and that type of thing. And so far, especially war in Russia and Ukraine, neither of them are huge economic superpowers. So, the market hasn’t been too concerned about it. But obviously, it’s been quietly escalating over there and if it continues to escalate and starts to impact the economics more, then the market could get upset about that. We also got tensions with China, which is much more of an economic powerhouse. So, if tensions do escalate there, especially over Taiwan, that could cause some risks in the market going forward.

But again, in all these cases, these risks are already priced a bit into the market. So if they don’t materialize, that actually gives the market more reason to go up. So those are the three risks/opportunities we’re looking at going forward towards the second half of the year. And, finally, we got this difference as I was talking about where the Fed’s making the case that they’re going to hold interest rates higher for longer. We’re going to stay at these levels through middle of next year, make sure they take care of that inflation. Market’s saying, “No, you’re not. You’re not going to make it there. You’re going to have to cut for X, Y, Z reasons.” That Jim we’ll talk about. And for that reason, interest rates have come down a bit and the market has gone up in response.

So, they’ve put themselves in a position where they can’t both be right. Somebody’s going to be wrong here. And, much of what you believe about the direction of the market over the next year or so has to do with which one of these cases is correct. So on the Fed case, I’ll give a few of their points. One, we talked a little bit about service inflation remaining high. So that’s a reason that they want to keep interest rates up for a bit to make sure they get that services inflation come down. But we also talked about how the job market remains very tight. So that means, lowering interest rates could spark a ton of demand, which would then reignite inflation. Some of those systemic risks they think have been contained. So they’re not as worried about needing to lower interest rates in order to bail out the economy for some type of systemic issue.

What else? They also are firm believers that price stability is more important than economic growth. If you do have a recession, that’s temporary, if you lose control of price stability, that can be forever, and that can have really dire consequences. So for that reason, they’re more comfortable with airing on the side of recession than they are with airing on the side of reigniting inflation. Plus, from a credibility standpoint, they were very late to start hiking interest rates. If they were now again too early to start lowering interest rates and inflation did come back, that would be a big problem for the Fed’s credibility. They’ve already been wrong once, don’t know if they want to make the same mistake twice, especially with so far the inflation has continuously been more persistent than people have expected. Initially they were saying this is transitory, supply chain issues, all that stuff. And again, and again, and again people have been proven wrong that the inflation has been more sticky than expected.

So those are some of the reasons the Fed is expecting to hold interest rates higher throughout at least the end of this year and likely into next year as well before they have to step in and start lowering rates to support the economy. On the other side is James.

James Bradley:

Yeah, I want to jump on all those arguments and operate against them from the market standpoint. In actuality, I think most of the market makers out there actually maybe really do believe the Fed, but the derivatives that they take positions in don’t necessarily bear that out. And so, if you look at the pricing of derivatives, they’re priced in a way that makes us think that at least some market makers see the Fed as loosening monetary policy before the end of the year, even though they say that they’re not. And why could that be the case? Well, companies are going to have to start refinancing debt. And, if they have to refinance them at these higher rates, that can have some pretty significant systemic effects that I think the Fed may be incentivized to try to ward off there.

The Fed does have a history, if you look back, of actually driving the economy into a recession when it takes steps to fight inflation. I’m sure that the members of the Federal Open Market Committee probably have history books and can see that that’s been the case in the past. Is inflation enough of a boogeyman right now that they’re really willing to take that step again and overtake the economy more than they necessarily need to? Especially given the case that most of the time when they do raise interest rates, it takes a good 6 to 9 to sometimes 12 months for the impact of that interest rate increase to take effect.

So, decisions that they make at Fed meetings right now, they’re looking not at what that’s going to do to the economy in the coming month, but I think they’re having to take a look at what that’s likely to do the economy toward the end of the year, maybe even into 2024. And as they look at that, they may start to see things that concern them a little bit more, as far as what they’ve done to slow down parts of the economy. Inflation has come down. If you look at most goods, lumber, steel, food, that type of thing, we’re back down to inflation rates that were we were at before we went into the pandemic in the first place. It’s the service sector where things have been a little bit more sticky, where inflation has held in. But a lot of the inputs to service sector have started to show signs of improvement.

So service sector inflation tends to come down a little bit more slowly, but we’ve got every indication that it looks like we should expect for service inflation to start to come down. And so, the Fed could see less of a threat when it comes to inflation the second half of this year. And coupling that with technology advancements that give more slack in the labor markets, I see every reason for the Fed to give the impression that they’re not going to cut interest rates before the end of the year, even if in the back corners of their mind, they’re making some allowance for it.

I think they gain nothing from getting markets stoked up right now. They gain nothing from having consumers get back into spending willy-nilly and driving that inflation back up. So, I’m just saying, if I were the Fed, I’d be saying probably the same thing that they’re saying as far as not letting up on a restricted monetary policy. But the market could be right, that they could have a little bit of a crack in the back of that logic and we might start to see a little bit of a give back, either on inflation rates or a slowing in the quantitative tightening that they do when they’re letting a lot of their holdings expire on the open market. So, that’s both sides of that case, I guess.

Sam Chaplin:

Yeah, it’s almost a [inaudible 00:22:14] for those and so much money riding on it, it would just be very entertaining to watch. But anyway, that’s our take. Appreciate you all tuning in and enjoy your summer. And we’ll see you next quarter.

James Bradley:

Happy Memorial Day, everybody.

Speaker 3:

The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be construed as investment advice or a recommendation regarding the purchase or sale of any security. There’s no guarantee that the statements, opinions, or forecast provided herein will prove to be correct.

The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be construed as investment advice or a recommendation regarding the purchase or sale of any security. There’s no guarantee that the statements, opinions, or forecast provided herein will prove to be correct.