Market Update - August 2022 | |
Image from the new Webb telescope that replaced the Hubble telescope. This is M74, the "Phantom Galaxy" 32 million light years away in the Pisces constellation. These deep space telescopes are also time machines; this picture shows what the Phantom Galaxy looked like 32 million years ago. | |
- After strong selling in early June, the market gradually chopped higher as earnings came in better than expected and the Federal Reserve hinted that they may not continue hiking interest rates aggressively.
- The U.S. economy has fallen into a mild recession as second quarter GDP came in negative at -0.9%. We now have negative real GDP growth in both 1Q2022 and 2Q2022, the classic two quarter definition of a recession.
- Inflation rose to 9.1% in June, the worst report in 40 years.
- Topics in this month's note:
- The inflation and interest rate puzzle
- Evidence of mild recession
- Was June "the" bottom?
- Fed policy analysis
- LIWM's bear market indicator
- The Circle of Life for investors
- Our market outlook
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Table 1: Performance update (as of 7/29/2022) | |
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During July, the stock and bond markets calmly chopped higher as corporate earnings rolled in and signs of economic deceleration became clearer. There was a sharp rally after the Fed meeting last week, as some interpreted Chairman Powell's comments as an imminent end to rate hikes. The riskier the sector, the better the performance in July. Gold, a defensive investment, was down, while tech stocks and small caps were up the most. Bonds rallied a bit also, but not with the euphoria of the stock market.
Year-to-date performance is solidly negative across the board. There have been no defensive plays outside of cash in this bear market.
We are nearing the end of a bear market rally, in our view. In May, we thought this could be a tradeable rally, but the violence of June's downward market movements to the record high inflation reports made it difficult to trust either the bond or stock markets. It is highly likely we have not seen the market lows of this cycle.
If you are overweight equity and losing sleep over the markets, this is a good opportunity to rebalance your portfolio. Call us if you'd like to discuss.
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The puzzle of interest rates and inflation | |
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A key question to understanding the markets today is answering the puzzle of inflation and interest rates. With inflation at 9%, why have market interest rates remained so calm? The answer is complicated, but let's give it a try.
Just as the new Webb telescope allows us to peer deeper into space and farther back in time, the massive debts of the world's governments, corporations and citizens tell us the story of the massive amounts of money that have been spent. Debt is a financial time machine.
If we look at our own financial lives, when we incur enormous debt, it is usually for something we expect to generate a return. Think of a property mortgage or an educational loan. We expect the property to provide us shelter at a cost less than rent and our education to teach us skills with which to make a living. We are required to pay back this money plus interest over a set period of time. Corporations make a similar decision when they incur debt, knowing it must someday be paid back.
With government debt, we can do the same analysis. Over the last 20 or 30 years, what has most government debt been used for? In some cases, infrastructure or education, but in most cases to cover routine expenses or our many wars. During the pandemic, emergency spending was used to prop up the economy using mostly borrowed funds.
In all cases, when the money was borrowed, it was immediately spent on that house, degree, factory, social security, health care or road. During the pandemic, money was injected into the economy at a much higher rate compared to the past. Looking at the pandemic stimulus spending and the resulting inflation, we can see that the government created much more demand than the economy could deliver.
This is further complicated by 1) supply chain disruptions, 2) Federal Reserve monetary policy over the last 10 or 20 years, and 3) currency reserves held in US stocks and bonds. The supply chain is like a giant slinky. The pandemic shutdown the economy, killing demand. In response, factories closed. Stimulus brought back that demand strongly, and the factories of the world have been struggling to catch up with demand ever since.
The Federal Reserve has been trying to stimulate inflation since the financial crisis. While they will be the first to admit their policy changes work slowly over time, the rapid rise of inflation has been a shock to them. After 2009, they have kept their Federal Funds rate at zero for long periods of time and bought trillions of US Treasury bonds to stimulate inflation. Now that we are experiencing very high inflation, they recently raised their policy interest rate to 2.25%. Is this a serious response to 9% inflation? I don't think so.
Our trade partners have built up enormous currency reserves to protect their currencies in an emergency and to suppress their currency in trade with the United States. This money is primarily kept in US Treasury bonds, although some like the Swiss keep it in US equities. These numbers are also in the trillions. Between the Federal Reserve and our trade partners, a large part of our national debt is owned by non-economic players. These investors don't care what inflation is nor whether they get an economical return on their investments.
Finally, in nearly all recessions, inflation typically falls. Our negative 2nd quarter GDP of -0.9% implies we are in a mild recession. When we consider the possibility of falling inflation from recession, the lack of bond market selling by government agents, and the end of pandemic stimulus programs, it is easier to understand why the bond market is not in a panic over 9% inflation.
What we see is that yields in the US 10-year benchmark Treasury bond peaked at 3.4% in June and have traded down as the economic news deteriorated. The Fed is still on track to raise rates to 3 or 4%, however. For political reasons, they cannot stop until there is a material improvement in the inflation situation. Ironically, the bond market expects inflation to peak soon, as Fed rate increases slow economic growth.
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Figure 1: Comparison of US 10-year yield and US 2-year yield 2008-2022 | |
Signs of modest economic weakness | |
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Let's review some of the signs of recession to determine its severity and progress.
One of the industries most sensitive to changes in interest rates is home building. Higher interest rates translate directly into an inability or unwillingness to buy a house. Sure enough, new housing starts are down 20% from their recent peak, hurting demand for lumber, steel, paint, building materials and construction labor.
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Figure 2: New home sales in the United States | Broad based indexes of economic activity are also weakening, but not indicating a severe recession. The Purchasing Manager Indexes (PMIs) are constructed from surveys of company buyers in many sectors. Because these surveys are monthly and fairly simplistic, they are very timely. When these indicators fall below 45, that is indicative of recessionary conditions for manufacturers. Currently, the indicators are 55 and 53. | Figure 3: PMI Indicators for services and manufacturing | Overall, the evidence on employment, industrial activity and retail sales indicate that this recession is a mild one so far. As the Fed continues raising interest rates, we may see conditions deteriorate further. | A lot has to go right for June to be "the" bottom | |
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Investors bet big last week on the following scenario:
- The Fed rate increases will soon stop.
- Inflation will quickly fall.
- The recession will be mild.
- Corporate earnings will remain strong.
Let's talk about some of these assumptions. The bond market itself is expecting the Fed to raise rates to 3 or 4% over the next year, before cutting rates. Is this bullish? Yes, but in 2023, not mid-2022.
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Figure 4: Federal Reserve interest rates implied by Eurodollar futures | |
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Similarly, there is great hope that a recession will cause inflation to fall. If we look at the 1970s, there is evidence that in a period of high inflation, inflation will fall during a recession. However, it took very painful medicine in the late 1970s to finally stop the inflationary cycle. In Figure 5, you can see that in 1970 the Fed had to raise rates to 9% in an environment of 6% inflation to trigger a recession that suppressed inflation.
What does this imply about the Fed's policy rate of 2.25% in a period of 9% inflation? We seem to be very far away from the inflation fighting policies of the 1970s.
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Figure 5: Inflation, Federal Funds rate and US 10-year yields 1960-1980 | |
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As for earnings and growth, higher interest rates imply a sharper slowdown in economic activity is in the future and not the past.
When we review these points, it is easy for us to conclude this is a bear market rally because there is more economic pain in the near future.
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Fed policy is not restrictive | Despite all the talk about fighting inflation, the Federal Reserve policy stance is anything but restrictive. By comparing the Federal Funds policy rate (FF), the US 10-year Treasury yield, and inflation, it is our view that current Fed policies are highly supportive of the current inflationary regime. | |
Figure 6: Fed policy framework | |
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Isn't there an indicator that ties all the critical variables together to give us a probability of a bear market? Yes, it exists, but is not regularly published by Wall Street research
Over the years, we've collected some helpful gems of Wall Street research. In one, the analyst measured the efficacy of hundreds of economic reports and listed them by order of importance. We took the 5 most important variables and included them in an indicator that generates the probability of a bear market.
The 5 most important economic variables for estimating likelihood of a bear market are:
- 10y-2y Treasury bond yield spread
- ISM purchasing manager's index
- Inflation
- Cyclically adjusted market price/earnings ratio (valuation)
- Unemployment
This indicator shows that there is still a significant probability of downside in the near future. The indicator has rolled over slightly, reflecting the current bear market, but there is more to go.
If you would like to see the contribution of each component to the probability of bear market, let me know and I will be happy to share it with you.
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Figure 7: LIWM's Bear Market Indicator | |
The Circle of Life all investors face | |
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It is helpful to remember that inflation, recessions, good times and bad times are all part of the normal environment experienced by investors. Nothing is new under the sun, as is said in Ecclesiastes.
However, we can read the signs of the times to determine where we are in the economic cycle. There is a time to be bold and a time to be cautious. This is a time to be cautious.
It is our view that the markets will not bottom until we get the classic signs of recession:
- Falling inflation
- Falling employment
- Falling earnings
- Falling interest rates
So far, we have only seen modest weakness in employment and earnings. Inflation and interest rates are still rising.
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Figure 8: The Circle of Life for investors | |
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The stock and bond markets are experiencing a bear market rally. These are short term rallies within the context of a longer bear market. Bear market rallies are common and useful for those who need to change their portfolios.
We expect the Fed to continue raising rates, earnings to fall, the economy to slow and inflation to eventually peak. However, these events are in the future and the path we travel to get there is still unclear.
Because of this treacherous market, we remain underweight equities, underweight bonds and overweight short duration Treasuries.
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As always, please call if you'd like to discuss:
Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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Lloyds Intrepid LLC (“LIWM”) is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from LIWM with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.
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