Written as of May 12, 2023
View the Nicola Wealth Investment Returns: April 2023
Highlights this Month
- Deciphering the caution signs
- Bond Market Action: wild swings leave yields looking skimpy
- The Fed presses on despite both the market and investors wearying
- Four key factors to watch: inflation, jobs, wages, and regional US banks
- US political influence and the debt ceiling
April in Review
Stocks generally continued their positive run in April, with the S&P/TSX Composite Index gaining 2.9% (total return CAD$) and the S&P 500 +1.6% (total return USD$). This leaves the S&P/TSX Composite Index +7.6% year to date, and the S&P 500 +9.2%. Like last month, however, market breadth continues to deteriorate, with fewer and fewer large stocks accounting for the majority of the gains. Using the equally weighted S&P 500 index versus a standard capitalization weighted index, U.S. stocks were only 0.3% higher in April and +3.3% so far in 2023. In fact, over 80% of the S&P 500’s gains year-to-date can be attributed to Apple, Microsoft, Nvidia, Meta, Amazon, Tesla, Alphabet, AMD, and Netflix.
According to JP Morgan, the S&P 500 is more concentrated now than during the Great Financial Crisis or the Tech Bubble, with the 10 largest stocks comprising nearly 30% of the index. From a thematic perspective, Generative AI, including Large Language Model has been a positive driver, partially offset by weak bank performance.
Deciphering the caution signs
Along with declining market breadth, there are a number of caution signs not readily apparent given the strong advance in the major market indices. According to Bank of America, long only managers and hedge funds are tilting their portfolios towards defensive sectors, like staples, health care, and utilities versus cyclical sectors like consumer discretionary, materials, energy, and technology. Hedge funds and large speculators have also accumulated their largest net short position on S&P 500 Futures since 2011. According to State Street, institutional investors have been reducing risk for the past three months, the longest stretch since 2015.
It's a tough market to forecast, leaving investors divided on what to do going forward. Quantitative traders, who allocate assets based largely on momentum and volatility (or lack of it) have been buying stocks. Discretionary investors, by contrast, position portfolios using economic and earning trends, have been trimming equity positions. According to Deutsche Bank, quant-investors haven’t been this bullish relative to so-called “stock pickers” since 2019. Based on Barron’s recent Big Money Poll, institutional investors are equally split, with 36% having a bullish view for U.S. stocks over the next year, while 26% are neutral and 28% bearish. According to JP Morgan, over 68% of clients polled see the S&P 500 below 4,000 by the end of the year, approximately 4% lower that where large-cap U.S. stocks closed at the end of April.
Bond Market Action: wild swings leave 10-year yields looking skimpy
While investors are debating the future direction of stocks, it’s the bond market where the real action has been. Growing stagflation concerns have resulted in wild swings in 2-year Treasury yields, while hedge funds are betting rates are heading higher and are net short 10-year Treasury futures to record levels. Bridgewater Research is also concerned yields could move higher as liquidity subsides. With the Fed and U.S. banks currently selling bonds, who will be buying from an increasingly indebted U.S. government? A recent Financial Times article pointed out nominal rates have risen but are still at quite modest levels relative to history. Assuming inflation recedes to around 2 to 3% and real rates reach an equilibrium of between 0 and 2%, short-term nominal yields could be expected to trade between 2 to 5%. Add on a modest-term premium of 1% for longer-term yields, and a reasonable range for the 10-year might be between 3 and 6% range. At the end of April, 2-year Treasury yields were 4.0%, while 10-year Treasury yields were 3.42%. Certainly, there is some room for 2-year rates to fall as inflation recedes, but 10-year yields already look pretty skimpy.
Credit spreads are also causing some confusion for traders. Depending on your perspective, credit spreads are either signaling a turn for the worse in the economy, or a soft landing. While investment-grade credit spreads did spike higher after Silicon Valley Bank (SVB) failed, they’re coming off unusually low levels and have since re-couped more than half their losses. The same goes for high-grade financial bond spreads. While big bank credit spreads haven’t rallied as much, when viewed over a longer time horizon, credit default swaps (the cost to insure bonds for default) for banks like Citigroup and JP Morgan remain well under control. Headlines of wider junk bond spreads signaling higher future default rates may be worrisome, but when viewed over the past couple of decades, investment-grade and high yield credit spreads still appear relatively sanguine. With the banking sector under pressure, this can change quite quickly, but so far, the credit market appears quite orderly. Spreads have widened, but are not signaling a hard economic landing, yet.
The Fed presses on despite both the market and investors wearying
The market for both stocks and fixed income appear right on the edge, and what could nudge them off the cliff is the Federal Reserve and future direction of short-term interest rates. After raising rates 25 basis points to an upper bound of 5.25% in early May, the bond market appears to be telling the Federal Reserve to stop raising rates. 2-year yields, which are a good proxy for where the market believes short-term rates should trade, are about 100 basis points lower than Fed Funds. While 10-year yields, which are better proxy for where investors see interest rates and inflation going longer-term, have also been trending lower even below both the Fed Funds rate and 2-year bond yields. However, the Fed remains relatively hawkish, according to JP Morgan’s recently launched AI-Powered model to decode the Fed and its future intentions based on Fed statements and speeches.
While the Fed may talk the talk, the market doesn’t believe they will walk the walk. According to Fed Funds futures, the market sees rates falling about 100 basis points to 4% by early 2024, and nearly 180 basis point by mid-2024. This is aggressive, especially when one considers the real Fed Funds rate is still negative based on core Consumer Price Index (CPI). On the other hand, Gavekal Research’s U.S. True Financial Conditions Index, which takes into account credit conditions and housing affordability, pegs conditions are at their tightest levels since Paul Volcker’s term to stem inflation in the 1980’s.
Four key factors to watch: inflation, jobs, wages, and regional U.S. banks
While it's not clear what the Fed should or will do in the coming months, we know it’s important. A recent Wall Street Journal article simplifies the issues by proposing four factors to watch in order to determine the Federal Reserve’s future intentions: inflation, job openings, wage rates, and regional U.S. banks. We explore all four in more detail below.
Inflation
We start with inflation, given it’s the main driver behind why the Fed has been hiking rates. As long as inflation remains above the Fed’s 2% target, the Fed claims they will continue to keep monetary conditions tight. While prices have started to moderate, as evidenced by declining CPI and Producer Price Index (PPI) inflation, it remains too early for the Fed to declare mission accomplished. According to the Fed’s preferred inflation gauge, core Personal Consumption Expenditures (PCE) actually increased in March, indicating prices remain sticky. As highlighted by the Dallas Federal Reserve, more than 40% of PCE components are still rising at more than a 5% clip.
Of paramount importance for the Fed are inflationary expectations. Once higher prices become ingrained, the fight becomes much harder. Fortunately, financial markets show inflationary expectation remaining very stable, with inflation breakeven rates continuing to trade around just over 2%. Breakeven rates aren’t always good forecasters of future inflation. Case in point they failed to predict the recent rise in prices, still predicting deflation a couple of years prior to the CPI spiking to 9%. Also, according to the University of Michigan, consumers expect prices to climb 4.6% over the next year, up from expectations of only 3.6% in March. Higher inflationary expectations were also evident in an April WSJ survey, with economists now expecting inflation to stay higher for longer.
Jobs
Contributing to the robust job market is prices stickiness and expectations elevated. Job growth remains strong, with the U.S. creating 253,000 new jobs in April and the unemployment rate falling to 3.4%, a 53 year low. As a result of the tight labour market, while wage growth may have stabilized, it remains too high for the Fed’s liking.
Wages
There are some signs the job market may be in the early innings of easing, however. Job openings have started to slide, while layoffs rose to their highest levels since 2020 last month. According to a recent ADP Research Institute survey of 2,000 workers, expectations for wage increases remain high, averaging 6.7% this year; however, companies are showing signs of pulling back. According to Bloomberg, companies are no longer mentioning labor costs during conference calls as much, preferring instead to talk about job cuts.
According to Strategas Research Partners, this shift towards layoffs follows a logical pattern in the business cycle. The Fed gets concerned about inflation, tightens policy by raising rates, company profits come under pressure, which results in layoffs. Higher unemployment results in lower wage inflation, as well as decreased consumer demand. Both should help keep prices in check. We have seen the Fed tighten policies, next would be declines in corporate profit, followed by an increase in unemployment. While corporate profits have declined, consensus estimates show only a modest decline in earnings in the first half of 2023 before recovering in Q3 and Q4. According to Bridgewater Research, the anticipated decline in earnings can mostly be explained by the undoing of the extra post-COVID gains rather than an economic slowdown. As pointed out by BCA Research, economists are forecasting a recession at the same time analysts expect a rebound in earnings. While this seems counterintuitive to us, based on first quarter earnings, they may be right. Q1 earnings came in largely better than expected, though partially to the detriment of estimates for Q2, Q3, and Q4.
According to Bridgewater, earnings need to weaken more for employment and wages to fall and help tame inflation. So far, companies have been able to protect their margins and profits by raising prices, but for how much longer? According to Morgan Stanley’s AlphaWise Consumer Survey, consumers are expecting to pullback spending in most categories over the next six months. If companies want to protect their bottom lines, cost savings and layoffs will be required because top line sales are likely to come under pressure.
Regional U.S. banks
The last factor mentioned in the WSJ journal article was stress in the banking system, particularly regional banks. The main concern for markets is that the decline in bank deposits will result in regional banks pulling back on lending, thus tightening credit conditions. While this can help the Federal Reserve in their quest to slow inflation, it risks doing so in a rapid and disorderly way. So far, regional banks continue to come under pressure, as evidenced by their declining share prices.
U.S. political influence and the debt ceiling
While not mentioned in the WSJ article, another factor we feel will influence the Federal Reserve is the debt ceiling which, unless Congress agrees to raise, could result in the U.S. Treasury running out of money and in technical default as early as June 1. Both Republicans and Democrats appear resolute in their positions, with House Majority Leader, Kevin McCarthy, demanding spending cuts and President Biden unwilling to negotiate until the debt ceiling is raised. U.S. sovereign debt credit swaps are trading at higher levels than either the 2011 or 2013 debt ceiling crises, but we still believe a last-minute deal will be made. It does, however, highlight the extreme political polarization in the U.S. right now and we don’t see it getting better anytime soon. With the 2024 presidential election right around the corner, both current President Biden and former President Trump have officially confirmed they are going to run despite the fact most American would prefer they not. According to a recent NBC News poll, 60% of Americans said Trump should not seek another term, while 70% (including just over 50% of Democrats) didn’t want to see Biden return to the White House. More encouragingly for Biden, however, a Wall Street Journal poll found, of voters who disapprove of both a Trump or Biden presidency, 54% preferred Biden versus only 15% for Trump.
Much rests with the Fed; what to do while we wait?
Given the current weight of uncertainty, an easy choice would be to follow the old market adage and “sell in May and go away” given May through October has historically been the weakest six months of the year for returns. Equity markets look strong on the surface, but only because of a handful of technology orientated companies primed to benefit from the coming AI revolution. Beneath the surface, managers appear to be more defensive, positioning their portfolios for a possible recession. Fixed income is more attractive, but credit spreads will need to widen more if a recession does indeed transpire. We believe a lot will come down to what the Fed does going forward, and the Fed is taking their cue from inflation. The market believes the Fed is going to start cutting rates in 2023, which would appear aggressive to us. Only if there is a financial crisis and/or sudden drop in economic growth is the Fed likely to pivot so quickly. If this environment were to play out, corporate earnings would be far lower than the market is currently discounting. The inconsistency we see in markets today is the assumption that inflation can move back to target without earnings moving materially lower. It can take 18 months or longer for higher rates to start to filter through the economy, and the Fed only started raising rates in March of last year. The Fed may blink, especially if Congress doesn’t get their act together, and raise the debt ceiling but not with inflation, employment, and corporate profits as strong as they are now.
