Written as of July 14, 2023.
View the Nicola Wealth Investment Returns: July 2023
Highlights this Month
- Unravelling the complex web of market signals and behaviour.
- Economic implications of rising interest rates for companies and households.
- Inflation remains a central focus for both the markets and the soft-landing thesis.
- The case of the bear steepener phenomenon.
- The impending surge in Treasury supply amidst ambitious capital investments.
- Navigating paradoxes and anticipating September’s uncertainties.
July in Review
The previous month witnessed a notable ascent in North American equity markets. The S&P/TSX climbed by 2.6% (total return in Canadian dollars), the S&P 500 gained 3.2% (total return in U.S. dollars), and the NASDAQ surged by 4.1% (total return in U.S. dollars). Notably, the S&P 500 is closing in on its early 2022 all-time high, but it's the NASDAQ that remains the frontrunner this year. The tech-heavy index has surged by nearly 40%, and the more concentrated NASDAQ 100 has soared by an impressive 45%.
In July, however, the standout performer was oil, as U.S. WTO Crude jumped by an impressive 16%. Scarcely any assets yielded negative returns last month; even fewer are in negative territory year-to-date.
Unsurprisingly, market sentiment has taken a sharp upward turn as investors increase their equity allocations. Conversely, bearish options are falling out of favour as traders exhibit a stronger preference for call options over put options.
Wall Street strategists find themselves racing to keep pace, given that the market continues to outstrip their year-end price predictions. Oppenheimer Asset Management recently revised their forecast to become the most bullish on the street. This adjustment leaves only a modest 7% upside for the remainder of 2023, based on the S&P 500's July closing value. In contrast, the average Wall Street projection implies a substantial 7% decline for the remainder of the year. Bloomberg advises investors to approach these target prices with caution. While the push to raise year-end targets could potentially create a self-fulfilling prophecy by compelling more equity purchases, these targets also underscore Wall Street's historical shortcomings in accurate forecasting.
Bloomberg's calculations reveal that adopting a strategy of buying the index whenever the 20-day moving average falls below the average Wall Street target, and selling when it dips below the 20-day moving average, would have yielded an annualized return of +2.2% in the post-2019 period. In contrast, a simple buy-and-hold strategy over the same period would have generated a much more substantial +11.5% return.
Indeed, forecasting the trajectory of markets is a daunting task, and the current market environment presents a particularly intricate puzzle with an array of conflicting signals. According to Citigroup's assessment, the U.S. economic surprise indexes have taken an upward turn. However, the survey data, which has been lacklustre, continues to present a mixed picture. Within this survey data, the services sector is displaying stability, but the manufacturing sector remains entrenched in contraction.
While coincident indicators show positive momentum, leading indicators paint a more sombre outlook for the economy's future trajectory. Adding to the complexity, the bond market appears more pessimistic than its stock market counterpart. While stock prices, continue their ascent, the yield curve remains persistently inverted, with short-term interest rates surpassing those of longer-term issues. An inverted yield curve is widely regarded as an almost unequivocal sign of an impending recession. However, even within the bond market, the scenario is nuanced. Although Treasury yields signal an economic downturn, credit markets exhibit relative calmness, characterized by narrow spreads that suggest a recession is not imminent. Notably, even typically riskier assets like bank shares and small-cap stocks have experienced a resurgence.
This intricate mix of signals highlights the perplexing landscape facing investors. The CNN "Fear and Greed" indicator recently entered the realm of extreme greed, a signal that, counterintuitively, raises concerns among contrarian investors. Simultaneously, Bank of America's Bull & Bear Indicator leans toward a more bearish sentiment reading, which could paradoxically be interpreted as a more bullish signal from a contrarian standpoint.
On the side of greed, sectors such as technology, meme stocks, and cryptocurrency have exhibited strong recent performance. However, data from Unlimited Funds suggests that Hedge Fund beta remains exceptionally low and bearish, contrary to the prevailing market exuberance. This intricate tapestry of conflicting signals underscores the complexity investors face in deciphering the current market landscape.
Unravelling the complex web of market signals and behaviour.
The current situation resembles a complex puzzle, leaving both investors and central banks grappling to understand how the pieces align. While stock prices appear to move higher in an orderly manner, bond yields pose a greater challenge to decipher. Morgan Stanley points out that volatility in short-term rates is heightened, but this seems to have little impact on stock valuations, defying the norm. Meanwhile, the behaviour of longer-term rates is equally perplexing. Despite a recent Bloomberg survey indicating that most economists and strategists anticipate lower long bond yields, 10-year yields increased last month.
Amidst this backdrop, a Deutsche Bank survey revealed market professionals' concerns about the repercussions of higher rates, with a majority anticipating ongoing market stress and accidents in the global markets. Surprisingly, these anxieties are not shared by stock prices and credit spreads, raising questions about the underlying dynamics. In an attempt to make sense of these complexities, we will explore some facets of this puzzle, particularly why higher rates haven't exerted more negative effects on the economy and the enthusiasm of risk assets, as well as why longer-term yields continue to rise.
The equity markets currently operate under the assumption that the Federal Reserve is adeptly orchestrating a soft landing for the US economy by reining in inflation to its target (2%) without triggering a recession. While the path is precarious, recent data suggests its feasibility and the likelihood of the Fed sidestepping a recession has recently increased. Strategas notes a decline in references to "inflation" and "recession" during earnings conference calls, while economists are scaling back their predictions of an impending recession. However, Société Générale points out that economists often cease forecasting a recession right before it materializes, highlighting the challenges they face in predicting economic shifts—similar to the difficulties faced by strategists in forecasting market trends.
Historically speaking, soft landings in the economy are a rarity. Alan Greenspan's apparent success in engineering one in 1994-95 is disputed by the bond market, considering the subsequent sharp yield increase and the financial crises in Orange County and Mexico. Alan Binder claims a fairly gentle landing in 2001, marked by a mild 8-month downturn he coined as a "recessionette." Yet, the possibility remains that the downturn is simply postponed. Jefferies notes that while consensus GDP growth predictions have risen, forecasts for 2024 GDP growth have trended downward.
While it's logically expected that higher interest rates would put a brake on the economy, the immediate impact is often delayed. This lag might be even more prolonged in this economic cycle, given that both consumer and corporate borrowers capitalized on the Federal Reserve's pandemic-driven rate reductions, securing fixed-rate debt at exceptionally favorable terms. Moody's data reveals that just over 11% of total household debt is floating, and the percentage of disposable income allocated to debt payments is a manageable 9.6%.
Furthermore, the effect of higher rates isn't unidirectional—while they increase the cost of interest expenses, they also amplify income from savings. As highlighted by the St. Louis Fed, the increased savings during the pandemic and the higher interest earnings on these savings have actually outweighed the added cost of interest rates on debt. This equilibrium has shifted only recently, now that excess savings have diminished to the point where interest payments are surpassing interest income.
Concerning these excess savings, Credit Agricole approximates that around $900 billion remains from a peak of $2.3 trillion, leaving many lower-income households with scant financial cushion. Additionally, households have likely reaped the benefits of remote work opportunities. Despite wage hikes, workers with the ability to work from home also experience reduced expenses due to decreased transportation costs, foregoing daily trips to coffee shops, and enjoying the liberty of shedding formal work attire in favor of more relaxed clothing choices like t-shirts and sweatpants.
Economic implications of rising interest rates for companies and households.
Similar to households, companies have managed to postpone the repercussions of higher rates by refinancing and extending their debt terms during the pandemic. According to Société Générale, U.S. companies have actually witnessed a decrease in net interest payments, despite the relatively substantial rate hikes. This is partly due to their astute move to refinance into economical fixed-rate loans during the pandemic. Additionally, akin to consumers, companies have also enjoyed elevated interest income from their substantial cash reserves. The inverted yield curve has led to significantly higher rates and returns on corporate balance sheets' cash holdings, while the costs of longer-term debt have remained steady.
Morgan Stanley's analysis indicates that only approximately 15% of global corporate debt requires refinancing before 2025, especially for S&P 1500 companies with substantial cash holdings. Among these companies, the top 10% in terms of cash on their balance sheets hold 70% of total cash but only 40% of total debt. Hence, these cash-rich entities have experienced minimal increases in interest costs, while the bottom 50% of companies have faced a less favourable situation.
Ultimately, more households and businesses will gradually start experiencing the impact of higher interest rates. However, the extent and duration of rate increases will significantly shape their ultimate influence on the economy. Economists view the Fed's July rate increase from 5.25% to 5.5% as their final move, yet they don't anticipate a rate cut until possibly March 2024 or even later. According to Apollo's Torsten Slok, the lagged effects of these hikes will continue to impede growth in the forthcoming 12 months. Bloomberg's Simon White asserts that the Fed's "long and variable lags" have yet to fully manifest, underscoring this by pointing out that it's only now that Fed-sensitive inflation is beginning to peak.
Inflation remains a central focus for both the markets and the soft-landing thesis.
Recent developments with inflation have generally aligned with favourable trends. Two key inflation indicators favoured by the Federal Reserve, namely PCE inflation and ECI wage growth, have both registered declines over the past months. The PCE "Super Core" is particularly important to the Fed, an index that excludes food, energy, and shelter costs. Over a 3-month annualized period, PCE Super Core decreased to 3.2% in June from 3.7% in the previous month. Similarly, the Employment Cost Index exhibited a moderation in total compensation growth to 4.5% in Q2 compared to 4.8% in Q1. Although this signals positive movement in wage growth, further efforts are required, as the generally accepted belief (by the Fed) is that 3.5% wage growth aligns with target inflation ranging between 2% and 2.5%. With job openings experiencing a decline, the Fed's intentions to curtail wage growth without precipitating significant job losses and a subsequent recession appear to be on track. Bloomberg notes that U.S. job openings in June reached their lowest point since 2021, while the ratio of job openings to unemployed individuals remained relatively stable.
While the Fed might find some satisfaction in the current trajectory of inflation, it would be prudent for them not to declare victory prematurely. As highlighted by Strategas, historical patterns indicate that inflation tends to manifest in multiple waves. This echoes historical occurrences such as in the 1970s. Crescat Capital suggests that we might be on the brink of entering the second wave of inflation, following the first wave that seems to be tapering. Early indications suggest they might be onto something, as food prices, oil, and gasoline prices have recently resumed an upward trend. Additionally, it's worth monitoring shipping costs and home prices, both of which have encountered upward pressures on their prices in recent times.
The case of the bear steepener phenomenon.
When it comes to inflation, a crucial element that investors perpetually strive to comprehend revolves around interest rates and the yield curve. In the context of the Federal Reserve's recent rate hikes and the anticipation of an eventual recession, the concept of an inverted yield curve seemed fitting. However, within the framework of a soft-landing scenario, one would anticipate the yield curve to embark on a journey of normalization, characterized by steepening and eventually reverting to its non-inverted state.
Interestingly, this anticipated yield curve transformation did indeed commence last month. However, the unfolding was quite different from expectations, as it was the ascent of long-term rates rather than the descent of short-term rates that engendered the curve's steepening. This market phenomenon, aptly termed a "bear steepener" due to the elevation of longer-term yields (resulting in losses for bond holders, hence bearish sentiment), is so rare that Strategas has dubbed it a "Macro Unicorn." Ordinarily, tightening cycles culminate in a "bull steepener," where short-term rates decline (leading to gains for bond holders, thus signalling bullish sentiment) while longer-term rates remain static or even slightly decrease. Curiously, the previous month observed 2-year Treasury yields decreasing by 2 basis points while 10-year yields surged by 12 basis points. By July 18th, the yield on 30-year Treasuries stood at 3.84%, ascending to above 4% by July 31st and further reaching 4.27% on August 11th – the highest since November of the prior year. This particular piece of the puzzle seems perplexing and out of place.
A potential rationale for the upward surge in bond yields could be traders factoring in a more enduring future inflation scenario. According to RSM's Joseph Brusuelas, the reliance of 10-year yields on market-implied inflation expectations has intensified since 2018. Notably, Zero Hedge highlighted the incipient pricing of persistent inflation risks into bond yields, evidenced by the most substantial increase in term premiums since the early 1980s. Bloomberg has reported that traders are positioning themselves for even further bond losses, as evidenced by put options on US 30-year Treasuries surging to their highest level since March. While this explanation might hold validity, it aligns more with the portion of the puzzle concerning lower inflation and the potential for a soft landing.
Another plausible explanation stems from investor apprehension over the escalating levels of US government debt, particularly in the aftermath of Fitch's decision to downgrade America's credit rating from AAA to AA+ last month. Critics raised questions about the timing of Fitch's move, considering the recent strides made toward achieving a soft economic landing. However, the mounting pressure resulting from higher rates has cast doubts on the sustainability and trajectory of the Federal Government's debt burden. Strategas highlights that the US has arrived at a fiscal inflection point, with net interest nearing 14% of tax revenue – a threshold historically employed by bondholders to impose fiscal restraint on government expenditures. The firm suggests that the US Treasury is faced with significant challenges, given the impending maturity of a majority of US debt in the coming years, coinciding with an impending surge in interest costs.
Morgan Stanley underscores the peculiarity of having such a substantial budget deficit when unemployment rates are historically low. This raises a pivotal question: in the event of a US recession, how much flexibility do policymakers possess to further augment the deficit? While debt levels measured against GDP have ostensibly receded since reaching a peak of 134.8% in Q2 2020, this decline is primarily due to elevated inflation bolstering nominal growth during a period of exceptionally low interest rates. Historically, the U.S. has benefited from persistently low or even negative real interest rates. However, this landscape has shifted with real rates inching upwards, converging with levels equivalent to the Fed's long-term real GDP growth projection. This transition poses a challenge in controlling the trajectory of debt-to-GDP ratios moving forward, prompting concerns regarding the extent of fiscal flexibility available for future maneuvers.
Nonetheless, these are more long-term issues and apprehensions. While Fitch's rating shift may raise immediate red flags, it likely wasn't the foremost concern among traders last month. Of more immediate significance is the question of who will absorb the multitude of bonds the US Treasury will inevitably issue? In a surprising turn of events, the Bank of Japan made a tentative move toward loosening its yield curve control policy last month, leading to a revival in Japanese government bond yields after years of dormancy. The already unappealing prospect of US Treasuries for Japanese investors is compounded by the recent surge in Japanese yields. Additionally, China is unlikely to step in as a substantial buyer, as its acquisitions of US Treasuries have dwindled, lagging even behind Japan's recent activity. Official net foreign purchases of US Treasuries have predominantly remained negative over the past decade. While US banks have been significant purchasers, they now find themselves grappling with substantial unrealized losses due to the sharp yield increases. The same holds true for the Federal Reserve. Although the central bank has been the largest US debt purchaser via its quantitative easing program, it's currently aiming to diminish its balance sheet by gradually trimming its substantial bond portfolio. Since last May, the Fed has already divested close to a trillion dollars, with more reductions in the pipeline. Although the Treasury Department has primarily been issuing shorter-term Treasury Bills, a shift toward a more balanced maturity portfolio is anticipated, including the sale of longer-dated Treasuries in the near future. These dynamics collectively contribute to upward pressure on yields, explaining the recent uptrend in longer-term yields. Ultimately, the issue isn't one of solvency, as the US can always meet its debt obligations due to its currency denomination. Rather, the pivotal question revolves around the identity of potential debt buyers and the accompanying price they'll demand.
The impending surge in Treasury supply amidst ambitious capital investments.
As the demand for Treasuries becomes an emerging concern, the trajectory of future supply is poised to soar even higher as the U.S. embarks on a series of substantial capital spending endeavours. Strategas recently spotlighted three significant programs that the Biden administration introduced post-COVID in a bid to stimulate domestic production: the infrastructure bill, passed in November of the preceding year, the CHIPS and Science Act (focused on bolstering domestic semiconductor production) ratified in July 2023, and the clean energy tax provisions enshrined in the Inflation Reduction Act of August 2022. According to Strategas, the disbursement for these initiatives is anticipated to gain momentum next year, ultimately culminating in its zenith in 2026. The financial outlay required to achieve carbon neutrality by 2050 seems boundless, with BloombergNEF indicating a staggering $196 trillion in global spending will be necessary by mid-century.
These figures loom large and are poised to exert strain on government budgets. On a more optimistic note, however, these investments are also expected to catalyze future productivity growth – an indispensable component for driving wage growth without stoking inflation. In a recent survey conducted by Bank of America among fund managers, a noteworthy 42% of respondents believe that investments in areas like Artificial Intelligence (AI) will yield heightened profits. Drawing parallels, Goldman Sachs draws a comparison between the potential productivity surge and historical innovation-driven productivity booms such as the advent of electricity and personal computers. The financial institution estimates that the adoption of AI could contribute an annual boost of 1.5% to productivity growth over a decade. Turning attention to clean energy pursuits, while the upfront expenses are substantial, so are the potential long-term dividends. According to BloombergNEF, solar power costs have dwindled to a mere 11% of their 2009 levels, and offshore wind prices have plummeted by an impressive 74% over the past ten years.
Unravelling paradoxes and anticipating September’s uncertainties.
The market's current focus is evidently centered on the dual dynamics of diminishing inflation and the persistent strength of the economy. Should the trajectory of inflation continue its downward trend, a natural outcome would be the ongoing rise in real interest rates, potentially affording the Federal Reserve the leeway to implement rate cuts – at least in theory. However, the current landscape presents an intriguing paradox: stock valuations have disentangled from real rates, signifying that a future adjustment might be in order, either for real rates to recede or for stock prices to experience a correction.
Concurrently, the intricate mechanics of monetary policy operate with a lag, implying that while the immediate sensitivity of the U.S. economy to heightened rates might be subdued, prolonged exposure to elevated rates carries the potential for vulnerabilities to surface.
In the ongoing effort to assemble the pieces of the puzzle, certain elements appear persistently enigmatic. A recent observation by the Wall Street Journal underscores the fact that while stocks have enjoyed a robust year, concerns loom on the horizon for September. Drawing from historical data spanning back to 1928, September emerges as the month with the lowest returns for the S&P 500. In the backdrop of escalating bond yields and the continued ascent of real rates, investors face an array of potential anxieties that could cast shadows over the market's outlook.
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.
