Brad M. Weafer, CFA | Chief Investment Officer
KEY POINTS
- Capital markets shrugged off tighter financial conditions resulting from rising rates and a regional banking panic to post materially better returns during the first quarter relative to last year.
- Despite downbeat forecasts, the U.S. economy has proven resilient and has supported continued growth in corporate profits.
- Despite the economy’s resilience, signs still point to being closer to the end of the economic cycle. With growth at risk, we remain cautious.
- Timing the end of the cycle with precision is challenging. Fortunately, bonds are currently priced for competitive returns and offer a more stable portfolio option.
First Quarter Results
The mood surrounding the capital markets was glum at the start of 2023. Investment returns for a traditional balanced portfolio consisting of bonds and stocks posted one of the worst calendar years on record in 2022. The U.S. Federal Reserve raised policy rates more aggressively than at any time in the last 40 years. Most professional economists predicted an imminent recession. Sentiment amongst professional investors was particularly poor and investment positioning was very conservative based on several survey measures we track. However, sentiment has a funny way of proving contrarian at extremes. When stretched too far in one direction, even a hint of positive news can help propel investment returns forward, which is exactly what we witnessed in the first quarter.
Performance for select asset classes as of 3/31/2023
The much-expected economic recession failed to materialize and as a result, corporate profit growth has been more resilient than feared. Stocks responded favorably as both domestic and international indices posted impressive results. Fixed income also had a strong performance as rates fell. Corporate bonds outperformed lower-risk government securities, but both had positive absolute returns. While not yet back to previous market highs, the standard balanced portfolio consisting of 60% stocks/40% bonds produced a healthy 5.6% total return in the first three months of the year. Compared to the dark clouds that hovered over much of 2022, the weather has been sweet in 2023.
First Quarter Drama
While investment results were solid, it was by no means a quiet quarter. In early February the Bureau of Labor Statistics reported strong employment data as the U.S. added over 500k jobs in January, well ahead of the less than 200k analysts had predicted. This was followed by strong retail spending, also ahead of expectations. The continued health of the American consumer was apparent, and forecasts for first-quarter economic growth moved higher. For U.S. workers and the overall economy, this is welcome news. However, equity markets reacted negatively. This paradoxical reaction highlights the struggle investors face between a healthy current state and policymakers’ attempts to cool strength to combat inflation. Coincident economic fundamentals are in a tug of war against future expectations of weakness from tighter financial conditions. After recently raising the Federal Funds Rate to a target of 4.75% to 5%, interest rate increases of the last year rival only inflation-fighting circumstances of the 1970s and late 1980s in terms of magnitude and speed.
Rising rates put pressure on borrowers of all kinds, both businesses and consumers. There is an old market adage that the Federal Reserve (‘the Fed’) raises rates until something breaks. The sound of something breaking happened in March with the collapse of Silicon Valley Bank (SVB) and an ensuing regional banking scare. As outlined in our last market commentary, “Silicon Valley Bank and the Safety of the Financial System”, SVB and other bank peers invested their assets with an imprudent level of interest rate risk. Rising rates put pressure on the market values of those investments, leaving weakness on their balance sheets. When that weakness became apparent, many depositor customers moved their assets away from SVB, triggering a downward spiral of confidence that ultimately led regulators to step in and close the bank. This scare put equity investors on edge, and stocks were under acute pressure in mid-March. Fortunately, the banking panic subsided with few signs of widespread financial contagion. Stocks rebounded to finish the quarter on a positive note.
The Economy vs. The Fed
Nobel Prize winner, economist Milton Friedman is one of the most cited experts on the effects of monetary policy. He contends that there are long and variable lags between changes in monetary policy and changes in the economy. The idea is that raising rates should lead to slower growth and lower inflation, but it takes time for the full impact to be felt. The variability refers to the unpredictable interval between rate increases and eventual decline in economic activity and inflation.
Raphael Bostic, President of the Atlanta Fed, described the situation in a recent note:
“A large body of research tells us it can take 18 months to two years or more for tighter monetary policy to materially affect inflation. You may be wondering: Why does it take so long? The US economy is a vast, complex ecosystem of interrelated forces. So, it takes businesses and consumers time to recognize, feel, and act on changes in financial conditions. For instance, firms are continually making capital investments that require financing. If a company has already started to build a factory or introduce a new product line, it will often continue to move forward rather than halt the project in midstream, even though financing costs have changed since it launched the venture. The bite comes for planned projects or expansions down the road; companies may be less likely to start these.”
The Fed began tightening its monetary policy only twelve months ago. As Mr. Bostic rightfully points out, it is not uncommon for the impacts to take longer to materialize. The exact timing has proven to be difficult to predict throughout history. Today’s economic cycle seems even more challenging to predict following the considerable uncertainty relating to exiting a global pandemic with major supply chain and commodity stresses that have been exacerbated by the war in Ukraine.
As challenging as timing economic weakness is, that does not seem to deter investors from trying. A majority of the indicators we track, particularly those that have a positive history of leading the overall economy, continue to suggest trouble ahead. Consider the Index of Leading Economic Indicators (LEI) released monthly by the Conference Board. This index is the summation of ten data series the Conference Board designed to signal peaks and troughs in the economy. The LEI fell in February, its eleventh consecutive monthly decline. There were negative or flat contributions from eight of the index’s ten components. Declines of this nature have preceded major economic declines in the past as you can see in the chart below. Weakness has been most pronounced in more cyclical and interest rate sensitive sectors of the economy including housing and manufacturing, which is typical.
Index of Leading Economic Indicators; Year over Year Percentage Change
Despite these forward-looking signals implying future weakness, the economy has maintained growth. Current estimates from the Atlanta Federal Reserve suggest the economy grew 2.2% during the first quarter. At the risk of sounding like a broken record, the most important factor contributing to making naysayer economists look foolish has been the health of the U.S. labor market. Although there has been a disconcerting list of high-profile layoff announcements, official data has remained encouraging. It is difficult to get too negative with an economy that added another 200k jobs in March after adding 11 million over the previous two years. A 3.5% unemployment rate ranks as one of the lowest readings of the last 50 years. Likewise, forward-looking signs of weakness from weekly unemployment benefit claims show no imminent signs of danger and also rival 50-year lows (see next chart).
Initial Weekly Unemployment Claims
The Late Stage of the Economic Cycle
It does not take a lot of courage to suggest the economic cycle is long in the tooth today. The end game of the cycle is ultimately a recession. Historically, recessions pose risks to earnings and stock prices that follow them. Of course, just as we have experienced over the last six months, realizing that eventuality can take time and stocks can prosper in the interim.
How should we assess that timing then? One tool we look to for guidance is the difference between short- and long-term interest rates, most commonly referred to as the shape of the yield curve. We show this on the following page using the two-year and ten-year rates on U.S. treasuries. In a credit-driven economy, different yield curve shapes have pronounced effects on activity.
To illustrate, consider a typical economic cycle. In a normal environment, you can expect a positively sloping curve; higher rates for longer borrowing terms. This is illustrated in the chart with a positive level above zero. In this kind of environment, banks can earn money by taking in short-term deposits and lending money longer-term. This spurs growth and hiring, creating a virtuous cycle.
When policymakers think that has gone too far and there are risks of inflation or the economy overheating, they attempt to restrict growth by raising short-term rates. This can go on for a time and the economy can endure through rising borrowing costs. This has limits though, which we are seeing today. Short-term rates can go to the unnatural position of being higher than longer-term rates, which is referred to as an “inverted yield curve”. This is shown at levels below zero in the chart. At this point, lending becomes less profitable, credit contracts, and growth slows, often to the point of economic contraction. For this reason, many forecasters use an inverted yield curve as a sign of future recession.
Back to timing the very end of a cycle. When a recession looks very likely or has already started, policymakers usually try and backpedal by cutting shorter-term rates to stave off the impending weakness. Rarely does this last-ditch effort work. At this point, the yield curve typically steepens again as shown using the red arrows in the following chart. You can see this cycle play out ahead of or coincident with past recessions and major bear markets for stocks of the last 40-plus years. We would see a rapidly steepening yield curve as a sign the end of the expansion phase of the economy has been reached.
10 Year Treasury Constant Maturity Minus 2 Year Treasury Constant Maturity
Taking this exercise to the current day, the warning signs look to be flashing yellow rather than red. The yield curve has steepened modestly off recent depths consistent with the credit concerns arising from the regional banking stresses (see the red box in the above chart). However, this has stabilized in recent weeks, though it certainly bears close watching going forward. Also in a positive read, we have likewise not seen confirming weakness from credit spreads or more high-frequency data points like credit card spending.
Bond Returns More Competitive
The higher the probability of and closer to the onset of a recession, the higher risk grows for stocks. Fortunately, we do not have to time this perfectly because we have investment alternatives. For much of the period following the financial crisis, interest rates have remained extremely low by any historical standard and as a result, fixed income securities offered little return. With the significant rise in rates over the last year, fixed income is now offering attractive yields. More stability and a competitive return leave us less inclined to assume equity risk at the margin. To illustrate the comparison, we reviewed the return you can expect from the S&P 500 based on current prices (earnings to price) versus the yield on a six-month U.S. Treasury note in the chart below. As you can see, today, the extra return expected from stocks (5.3%) is near 20-year lows relative to the expected return from short-term bonds (4.9% in this case). Although less exposed to future growth, bonds should offer relative safety against growing risks in stocks.
S&P Forward Earnings Yield minus the 6-month U.S. Treasury Yield
Portfolio Positioning
Recessions pose risks to corporate earnings and to stocks. Time may be running out on this cycle, but volatility and short-term weakness is part of the tradeoff we assume to invest in securities with growth potential. Ultimately, fortune is on the side of the patient investor willing to bear that year-over-year variability. The global economy has proven remarkably resilient through the ups and downs of cycles over many years. As we’ve discussed, determining the exact end of this economic cycle is nearly impossible, and attempting to be too precise has the potential to do more harm than good. Our stock exposure is currently slightly underweight, though stocks remain an important part of client portfolios. Fortunately, these portfolios are broadly diversified and maintain exposure to a variety of asset classes including U.S. Treasury and high-quality corporate bonds, which could appreciate in value should stocks falter. Further, where appropriate we have increased exposure to alternatives such as private credit and managed futures, assets with characteristics which differ from traditional stocks and bonds. These asset classes complement high-quality stocks marked by high profitability, low leverage, and durable growth in cash flow and dividends, which have proven to offer above-average returns with lower volatility. Portfolios constructed with diversified asset classes and quality stocks should continue to reward investors over time.
If you have questions about the capital markets, your portfolio, or how your assets are invested, please reach out to your wealth manager. We are always happy to take your calls and questions.
Market Commentary Disclaimer
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.
Professional Designation Minimum Requirements Disclosure
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA level exams.