The last two trading days of April made it possible for the NYSE, S&P 500, and Nasdaq to squeeze out positive gains for the month. Only the Russell 2000, which has a higher allocation to the Regional Bank sector, finished lower for the month. While we should be satisfied with any monthly gains after last year, it is discouraging that the overall market has been relatively flat during what typically is the strongest part of the Pre-Election Market Cycle. The chart below shows the expected performance of the S&P 500 during the Pre-Election year based on all years back to 1949. While 2023 started strong, we have been sideways at best since the start of February.
This sideways period over the last three months is discouraging since it goes against historical expectations.
Now the market is entering what is historically a consolidation period for the Pre-Election year market. Over the six months between May and October, the S&P has averaged a return of about 1.9% or around 0.30% per month. Since the market has been flat over the last three months, the next six months may carry more volatility than expected.
When the market does not perform as expected, there are usually one or two external issues distorting historical data and reality. Today it feels as if there are many different external issues that the market is fighting daily. Below we want to lay out some expectations for the ‘path ahead’ with the significant issues and how they will affect the market over the coming months.
The Federal Reserve and Interest Rates
Instead of waiting until the June FOMC meeting to announce they will pause interest rate hikes, the Fed should call an emergency meeting for tomorrow and immediately cut the Fed Rate by -1.00%. History shows that every time the Fed Rate rises above the yield on the 2-Year Treasury, the Fed has tightened too much. Currently, the Fed’s policy rate is about 1% higher than the yield on the 2-Year Treasury. Another signal that the Fed has been too aggressive is the face that the current 2-Year Treasury yield of 4.00% is roughly the same yield the bond had in early September of last year. This may not mean anything to most investors, but when you factor in that the Fed has raised the Fed Rate six times over these eight months for a total increase of 2.75%, the 2-year Treasury sends a clear message to the Fed that they need to stop.
Moving forward, we expect the Fed to announce a pause at the next FOMC meeting on June 14th, but we do not expect the Fed to indicate that they wish to cut rates later in the year. While the bond market and certain futures contracts show that the Fed should already be cutting rates or getting ready to cut, the Fed’s ‘transitory inflation’ debacle will keep them stubborn until inflation is in the rear-view mirror.
Rate hikes are over, and although they are talking tough, the Fed will have to ease policy in the same fashion in the fall.
The Fed Balance Sheet
While almost all focus of Fed activity has been on their rate policy, most investors seem to forget that the Fed is still fully involved in the quantitative tightening program they started a year ago. Although the first three months of the program were a smaller amount, since September of 2022, the Fed has been rolling off or not reinvesting $95 billion worth of US Treasuries and mortgage-backed securities (MBS) from their balance sheet each month. This is a reversal of the massive quantitative easing program restarted to help the US economy function during the Covid-19 pandemic.
During easing periods, the Fed will buy up US Treasury and mortgage-backed securities to generate higher liquidity throughout the US economic system. During tightening periods, the Fed will no longer reinvest maturing assets on their balance sheet, forcing market participants to buy up these assets when reissued, effectively reducing liquidity in the economy. While the full extent is unknown, quantitative tightening produces similar economic results as the Fed raising interest rates. Over the last twelve months, the Fed has increased rates by 4.75%, which is technically higher because of the Fed’s almost $1 trillion in balance sheet reductions.
While we favor the Fed retiring quantitative easing and tightening forever since it distorts actual market values, we know the tool is much too powerful for the Fed to relinquish. Our opinion toward this tightening period is very similar to our view on rates in that the worst is behind us. Over the coming months, as the Fed pauses, we assume they will reduce the monthly amount or completely shut down their balance sheet runoff instead of cutting rates.
The Debt Ceiling
The market is currently living in a period of ‘political purgatory’, once again fighting the political headwind created by the upcoming debt ceiling drama. This play has occurred many times over the past two and a half decades on Wall Street, always increasing the overall volatility in the market before our political parties reach an agreement.
The primary issue with these debt ceiling agreements is that it usually comes with kicking the can down the road and no major fix to the system. It is always guaranteed that our leaders will have to fight out the same problems in a year or two.
Since 1941 there have been 86 yearly debt ceiling increases, roughly one increase yearly. Both political parties are almost perfectly equal in raising the ceiling, with Republicans raising the debt ceiling 46 times for a total increase of 276%, while Democrats have raised the ceiling 40 times for a total increase of 298%. There is no difference in long-term increases between parties.
Many people compare the current debt ceiling battle to the last serious debacle in 2011. The setup of the government at that time was the same as today, Democratic President and Senate with a Republican House. Many investors remember that the late July and early August market was not one of much fun and enjoyment. The S&P 500 in 2011 saw about a 15% drop over the last week of July and the first week of August, much of which many investors today attribute to the debt ceiling crisis. While the debt ceiling debacle of 2011 affected the market’s performance over this period, we must also remember where the global economy was. Specifically, the global economy was facing of the European Debt Crisis, with the EU trying desperately to keep the weakness in Greece and Italy from spreading through the rest of the region and the world.
While today we have a much more toxic political environment in our country than we did back in 2011, the US and global economy are much stronger today and not facing the massive unknowns associated with the European Debt Crisis. The end of May might see some increased volatility as we reach the arbitrary June default date set by Janet Yellen, but eventually, an agreement will be reached, and the ceiling will be raised. The market should quickly gain back what, if anything, that was lost due to the volatility caused by the debt ceiling, and we will once again kick this crisis down the road to deal with it again next year or the year after.
Inflation
Inflation remains elevated above the Fed’s 2.0% mandate but has been cooling over the past few months. While inflation will remain sticky in certain areas of the economy, there are numerous indicators that help show that overall inflation is decelerating. We choose to focus on the two below:
Crude Oil - since peaking in June 2022 at $125 per barrel, we have seen brent crude drop by more than 40% per barrel. This 40% drop has occurred while the conflict in Ukraine is still occurring and OPEC+ has cut production. It will be hard for inflation to remain elevated, with oil losing value.
US Rent Prices - similarly, rental inflation is coming back down to earth. While still historically high, we have seen rental inflation start to fall quickly from its peak in September 2022. Shelter makes up about 40% of the CPI index. Hence, seeing rental prices continue to fall with the average sales prices of homes throughout the country presents another positive sign that the worst of inflation is behind us.
Inflation will continue to cause market anxiety over the coming months since we know that one hot data point will lead investors to speculate another massive round of Fed hikes ahead. But in general, as we have seen for most of the last six months, we expect inflation to continue to drift lower in the months ahead. It will take time to reach the Fed’s 2% mandate, but we think they may need to adjust their final level of inflation higher for a period.
Recession
As we said at the start of the year, we are still waiting for the most talked about recession in history to occur. Instead of happening in the first half of 2023, financial experts expect the US economy to enter a recession later this year or early 2024. Just remember, a broken clock is right twice a day, so you can guarantee all these recession experts will continue to threaten the worst economically if only for self-satisfaction.
What has become evident over the last year and a half, given the insane policy action of the Fed, periods of extreme inflation, runaway commodity prices, supply chain disruptions, and a global conflict in Ukraine, many have underestimated the strength of the US economy. This leads us to expect two outcomes for the coming months:
Soft Landing- this remains the expected outcome of the Fed; they believe that they will be able to navigate a soft landing for the economy, bringing inflation down to the 2% mandate level without causing a recession. The key here will be unemployment levels, which have remained much stronger than anyone would have expected a year into a massive rate hiking cycle. Moving forward, we need to see monthly unemployment levels begin to rise, but in a controlled fashion to allow for a soft landing to occur. Also, a steady increase in the unemployment level would help protect overall corporate profits.
Hard Landing with Declining Inflation- history should tell us that this is more of the expected outcome given the ineptitude of the Federal Reserve. A hard landing would occur where the unemployment level begins to increase much faster than expected, increasing the risk to corporate profits and overall strength within the economy. The one benefit that the Fed has working in its favor in helping the economy avoid a significant recession is that their rate hikes were historically front-loaded, a move in past markets that would have destroyed earnings and revenues. Surprisingly company fundamentals have remained very resilient up to this point. With the Fed close to pausing, there is an opportunity that the expected significant deterioration in company earnings and revenues will not occur.
It’s been said that economists have called nine of the last five recessions. We assume this holds true moving forward, as recessions are challenging to call from a technical standpoint. From a ‘feeling’ standpoint, it’s safe to say that we were in a recession for much of last year, but the textbook definition does not fit, given the strength in unemployment we have sustained. For example, in early 1929 when the Harvard Economic Society declared that a depression was ‘outside the range of probability’ or December of 2007, we had already begun to see an economic downturn, yet economists expected the US economy would grow by 2.2% in 2008. Our opinion is that if we enter a recession, it will be very shallow and short-term because everyone is calling for a recession.
May and the Months Ahead
The market has been surprisingly range-bound for the last 12 months. While there have been some extremes in price, the S&P spent most of the previous year in a 7% trading range. Given the magnitude of issues the market has faced in the last year, it once again helps display the market and the U.S. economy’s overall strength. We expect this trading range to continue for another few months, with a slightly bullish bias.
While we continue to see superior strength in our daily Money Flow numbers, with 84% of the S&P 500 constituents having positive money flow as of the end of April. The offset to this strength is that the relative performance of most market participants has weakened over the last few months. This has caused the market to become increasingly narrow, meaning that the market is being supported by fewer and fewer stocks. Much as we have seen in the past, the mega-cap tech names like Microsoft, Apple, and Nvidia have done a lot of heaving lifting so far this year. Currently, the levels of our relative performance and strength indicators are at multi-year lows, so we expect these indicators to begin to reverse and broaden in a positive manner.
We anticipated some weakness for May over the first three weeks of the month, resulting in a low around May 24th-26th. But we know that any move higher or lower will greatly be affected by how long the market will be held hostage by the debt ceiling crisis. Whenever the May low is reached, we look for a healthy rebound for most of June. From there, we expect the market to continue to be range bound until a low in late September or early October, which should lead to a very strong end of 2023 and into 2024. While the market may remain volatile over the coming months, our base case remains that the market lows for this cycle are behind us.