Vigilare Wealth Management 2023 Q3 Commentary
The markets stumbled in the 3rd quarter. The U.S. Federal reserve continues to battle inflation with rate hikes and its “higher for longer” mantra. This has caused the stock market to struggle, even after the horrific year of 2022. It may not appear so on the surface with the S&P in double digit gains for the year, but if you strip away the top 7 tech stocks in the S&P 500, the index would actually be down for the year. This concentration in performance is highly unusual and not seen since market tops in 2000 and 2007.
As mediocre as stocks have been for the last year and a half, the bond market has suffered the longest and deepest losses, in U.S. history. This has shattered the conventional belief that bonds can offer the reliable “defense” in a diversified portfolio. Because of rising interest rates, the U.S. Treasury bond market is down an astonishing 50% in price since the peak in 2020! The more widely used aggregate bond index is down over 20% from its peak. These are unprecedented drawdowns for bonds! We have written extensively about how vulnerable bonds were because of the ultra-low rates coupled with the looming inflation problems, and how unaware most investors were of this risk. This bond carnage can continue although it is our view now that we are close to a near-term peak in rates and that bonds could even be the preferred asset class over the next 6-12 months.
While bonds have absorbed the wrath of an aggressive Fed and an inflationary economy, stocks have fared relatively well. The economy has avoided recession so far surprising many, including us. Most economists now expect a soft landing or a “no landing” outcome because the economy has managed to avoid a recession up to this point. Haha. Consider that just because it hasn’t happened doesn’t mean it won’t happen. There can be significant lags between when early recession indicators start signaling trouble and the actual onset of a recession (again, 2000 and 2007). These lags can be anywhere from 6-18 months, or more. We are approaching the latter end of that range in the 4th quarter and early next year so the debates should be settled shortly.
Why has the economy defied the projections of recession and been so resilient? First, it does take some time for rate hikes to start to bite. There is an expectation from investors in real estate and other debt borrowers that they can simply “wait out” the rate cycle and that the Fed will soon start to lower rates again. This goes against the Fed’s own mantra of higher rates for longer. At some point one side must give: investors accept higher rates and adjust, or the Fed does lower rates. Our view is that this time the Fed is serious about keeping rates high to battle inflation and they won’t lower rates prematurely (unless there is a financial shock). Secondly, the residual stimulus from recent Congressional Covid bills has been much larger than anticipated. And by a mile! Since April of this year, the U.S. has added $1.7 trillion in new debt. For perspective, it took from the inception of the U.S. to 1985 to get to the first $1.7 trillion and we added that in just 6 months. Wow. In fact, today the U.S. is running the largest fiscal deficit ever, outside of being in a recession or WWII. This steady flow of government spending has helped support the economy and, in turn, the stock market and earnings.
Despite this economic resilience. we still see significant risks ahead in the U.S. economy. Our base case is a Recession within the next 6-12 months. Here are some of the risks that could tip the U.S. into recession. First, the ongoing effects of Fed rate hikes and persistently high borrowing costs may start to have a deeper effect on the economy (Fed rate hike cycles have led to recessions 8 of the last 12 times). Second, inflation continues to be a nagging problem that just won’t go away. Worker strikes are becoming more commonplace, which will have an impact on productivity and profit margins. Additionally, high oil prices can persist and have an impact on inflation and consumption. Also, many fiscal accommodations are expiring such as the Employee Retention Credit and the moratorium on student loan payments to name a couple. Furthermore, we can expect more government shutdown showdowns and a dysfunctional Congress which will make future bailout stimulus plans unrealistic.
At the core of our economy is the consumer which is in a vulnerable state. Most households have spent down the savings accumulated during the pandemic. And inflation has taken its toll. This is creating great hardship on the middle and lower class. An example of how challenging the environment is for the typical person: The average monthly payments – new home $2,900, rental $1,900, new car payment $740, used car payment $530, student loan payment $500, Credit card balance $7,300 with interest at 24% (all-time high). To cover a house, student loan, car, and credit card payment it would take 90% of the average person’s median pre-tax income. This is clearly not sustainable.
This can persist for a while longer with a strong job market and/or additional government stimulus. But this state is an extremely fragile one. If the Fed were to pre-emptively bring down rates, this could soften the blow, but as we mentioned, that is unlikely. We believe that these pressures outlined will start to have an impact on economic growth and corporate profits. The tip-off to the onset of a recession will be in the job market. To combat slowing demand, companies will need to start laying off workers. This could happen slowly or because of a shock in the system like a large bank failure or a geopolitical event. Unfortunately, stock valuations are too high to absorb these potential risks. This is the point when a recession will be evident, and stock markets will need to revalue (I.E., go down).
Even with all this gloominess there is the potential for a strong 4th quarter year-end rally. There is a seasonal tendency for the market to finish the year strong. Even in the depths of the financial crisis (right after Lehman Brothers failure) the market staged a 20% rally to end the 2008 year. We would not be surprised to see a tailwind of seasonality and have stocks markets finish strong and even possibly surpass all-time highs. A Fed pause and a short-term rebound in earnings could be the catalyst. (Remember markets like Fed pauses but fear Fed pivots). This would not change the longer-term outlook of a slowdown, just simply part of the ebbs and flows of stock markets.
The summer of Taylor Swift and Beyonce concerts along with Barbenheimer in theatres kept GDP grooving through the summer, but not even Taylor can help avoid what could be a cold winter and/or late spring. The combination of elevated stock prices and great economic and geopolitical uncertainty, have us the most concerned we’ve been since leading up to the financial crisis in 2007/2008. Not all is doom and gloom. It is important to be reminded that fear and volatility do eventually lead to new and extremely profitable investment opportunities. In the meantime, short term treasuries are paying better than in decades and long-term bonds are starting to look attractive and could be the standout performer in a slowdown.
Thank you for your trust.
The Vigilare Wealth Management Team
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