As the summer season unfolds, I'm reminded of the rhythms and rituals of baseball. Much like the strategies employed in the intricacies of a baseball game, managing investments requires a keen understanding of the times and the ability to adapt to changing conditions. Our Great American Pastime can sometimes be a welcome reprieve from reality. On a recent trip to the College World Series, my father asked, "Son, what's happening out there in the real world?" I reflected on our current position in the economic cycle. It's clear -we're in the late stages, akin to the tense moments before the final innings. The outcome is uncertain, and the game's momentum can swing unexpectedly, but we do have a grasp of the key stats on our economic scoreboard. Inflation is an all too familiar opponent, stubbornly impacting economies worldwide. Economic growth, our closing pitcher, is showing signs of fatigue with a slowing pace. Asset prices put a lot of runs up in the early going but may be entering a slump as we try close out the game with a win.
Inflation continues to be a global phenomenon with most major central banks pledging to sustain elevated interest rates for an extended period. Although inflation indicators in the U.S. have likely peaked, core inflation has surpassed headline inflation in recent months – an indication that the less volatile components are well entrenched. The Federal Reserve (Fed) halted its ten-meeting streak of interest rate hikes in June, partly to provide the U.S. Treasury space for debt issuance resumption following a six-month hiatus. In his semi-annual testimony to Congress, Fed Chair Powell suggested that two additional rate hikes could be imminent, reaffirming the Fed's adherence to its 2% inflation target. The road to inflation control, as Powell admits, “has a long way to go.” Indeed, some softening is occurring as the economy slows. We anticipate upcoming inflation indicators to reflect more current shelter data, given the declining rent rates since their peak last year. The labor market continues to exhibit a Jekyll and Hyde relationship, simultaneously supporting high inflation whilst holding a recession at bay. Ultimately, productivity growth will be a crucial determinant in avoiding a repetition of the 1970’s stagflation environment.
For now, corporate revenues continue to be the benefactor of the prevailing inflationary environment. However, as the year advances and labor markets begin to falter, this will likely shift. Many large corporations' growing demands for workplace returns stem from record-low productivity levels. The uptick in unit labor costs (ULCs), driven by weak productivity, reinforces core inflation. Simply put, companies are spending more to produce their goods or services due to high labor costs, causing prices to rise further. The challenge now is to enhance productivity by curtailing labor costs at a pace faster than revenue reduction (ChatGPT to the rescue?). As it stands now, high ULCs compel companies to increase prices to safeguard margins, risking a wage/price spiral and emphasizing the urgency of inflation control. Stubbornly high inflation in a low growth or even recessionary environment is what is characterized as stagflation in the 1970’s. As the Fed navigates towards a soft landing at the end of this economic cycle, it cannot overlook past missteps.
Case in point, in 1967 the U.S. faced an economic slowdown with similar conditions to those existing today. In hindsight, the Fed’s failure to maintain the fed funds rate more than nominal GDP resulted in the easing economic financial conditions too early amid low unemployment and elevated ULCs. For reference, the annualized 2022 nominal U.S. GDP was more than 7% and the current fed funds rate is 5.25%. The aftermath in the late 1960s was soaring stocks, dipping bond values, resurgent inflation, and eventually, a forced, harsh Fed tightening that inverted the yield curve and induced a recession and stagflation in the 1970s. Today, the scenario appears eerily familiar. ULCs and Core Inflation are both well above pre-COVID trends. While growth in the money supply is contracting year-over-year, its level is still $3.4 Trillion above its pre-COVID trend. Concurrently, Federal government spending exceeds their trend by $1 Trillion. This is why the Fed is indicating that interest rates will likely climb higher this year and stay there for an extended period. The Fed desperately wants to avoid a recurrence of previous mistakes that allowed inflation to hang around for too long but also understands that slower economic growth is a necessary consequence.
Perhaps counterintuitively, the debt ceiling resolution has reduced overall liquidity within the financial system in the short run. In the long run, the national debt is projected to reach 181% of GDP by 2053, possibly necessitating mandatory spending reforms, to include Social Security and Medicare. The federal government is projected to borrow $200 Billion to replenish the coffers. Ultimately, the capital required to cover this large amount of borrowing activity comes from net savings, typically in the form of bank reserves, and are therefore not available to be spent or distributed into the economy in the form of new loans. This, coupled with the ongoing tightening of bank lending standards following recent regional bank collapses, likely challenges the appetite for risk assets, such as high-growth stocks, going forward.
The situation is further complicated by the impending expiration of federal student loan forbearance and mandatory repayments resuming in October. To lessen the burden, President Biden intends to amend the Higher Education Act of 1965 to reinstate student debt relief. Additionally, he plans to introduce a 12-month repayment program to assist student loan borrowers, preventing loan defaults and protecting their credit ratings. Meanwhile, consumer credit card debt levels continue to surpass previous records, and higher interest rates will undoubtedly make a significant dent in consumer savings. Yet, the resilience of consumers, particularly within the service sector, has kept economic growth positive (have you checked airline prices recently?). However, once savings are exhausted, a deleveraging phase is expected, which could considerably shock financial markets.
By the end of June, the S&P 500 officially entered a bull market, as indicated by a 20% appreciation from recent lows. However, the rally’s breadth, or lack thereof, is a bit concerning. The Year-to-Date (YTD) gains in the index have been attributed to seven stocks (Apple, Alphabet, Meta, Microsoft, NVIDIA, Amazon, and Tesla). While most of those names are no strangers to market leadership, NVIDIA’s meteoric rise in share price over the past year has led it to become the latest of a select few companies to reach the Trillion-dollar valuation threshold. Although NVIDIA’s prospects as a major player in the Artificial Intelligence (AI) space are promising, we remain wary that its true value may fall short of heightened expectations. This narrow leadership breadth suggests a lack of market resilience, which could pose risks should exuberance wane.
The market's leading price-to-earnings (P/E) ratio significantly surpasses historical trends, even in the face of declining corporate earnings over the past two quarters. Our base case scenario anticipates further pressure on corporate earnings, making multiple expansion challenging in a high interest rate environment. U.S. Treasury yields, offering an attractive alternative to the earnings yield provided by equities, could dampen the prospects for further rallies.
The U.S. treasury yield curve inversion extends into its twelfth month, the third longest on record, casting a looming shadow of potential recession. Historically, twelve months is the average lead time between an initial yield curve inversion and the onset of a U.S. recession. In light of this, we have been content with collecting higher yields at the shorter end of the high-quality fixed income market, while awaiting a more attractive risk-reward profile from the speculative end. In our view, the corporate earnings and cashflow fundamentals do not justify spreads at current levels. Historically, corporate margins tend to peak 6 – 12 months before economic and credit contractions commence. With yields and spreads likely to rise further in 2023, we anticipate future debt refinancing to add to the cash flow stress for many borrowers, causing credit spreads to widen correspondingly.
As we stand at the plate in the late innings of this economic cycle, it is clear that navigating these final moments requires careful attention to the rapidly changing economic landscape. High levels of inflation remain an impediment to sustained economic growth. Restrictive Monetary Policy is working, but the job at hand still has, as Fed Chair Powell conceded, "a long way to go." The Fed's cautious approach to the current inflationary environment, learning from past missteps, likely means higher interest rates for an extended period. This course of action is meant to curb stubbornly high inflation while acknowledging that slower economic growth may be a necessary consequence. Meanwhile, fiscal policies, despite their expansive nature, are straining liquidity and spending power, posing a challenge to risk assets.
The resilience of the service sector continues to provide a lifeline, but how long before the well of savings runs dry? The equity markets' bull run, concentrated around a select few, raises concerns about the robustness of this rally. With corporate earnings under pressure and P/E ratios surpassing historical trends, the road ahead for equity markets could be bumpy. Lastly, the persistent inversion of the U.S. treasury yield curve casts an ominous shadow over the prospect of an impending recession. However, we're leveraging these changing dynamics, focusing on high-quality fixed income at the shorter end while awaiting a more enticing risk-reward profile. The final score of this economic cycle remains uncertain, but what is certain is that the decisions we make in these late innings will shape the trajectory of the game.
Jim Ulseth has been working in the ultra-high net worth advisory space for over a decade.