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Per Stirling Capital Outlook – May

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Last week, we had an opportunity to interview with one of our favorite Reuters reporters, who we have worked with for years.  However, this time, rather than having one specific topic that she wanted to address, she said that she was “interested in what’s on [our] mind broadly”. 

To no surprise, particularly as a team whose job it is to develop high-conviction macroeconomic opinions, being offered an invitation to talk about whatever is top of mind was basically an “offer we couldn’t refuse”, to quote Al Capone’s character in The Godfather movie. 

Indeed, it was an offer we gladly accepted, and we proceeded to discuss a wide array of issues, including the economy, the banking crisis/credit crunch, the debt ceiling, inflation, monetary policy, domestic & global equities, and the fixed income markets.

Hopefully, you will find reading this commentary to be a similarly-compelling offer, as we take you on a tour of the Chicago River current macroeconomic environment, starting with a big picture look at the U.S. economy itself.  While it is self-evident that the outlook for the economy is always a very important macroeconomic influence on investment markets, we would argue that it is it of particular importance today, when the Fed is trying to engineer a “golden mean” outcome, where they slow the economy just enough to bring inflation under control, but manage to take their foot off of “the brake” just in time to keep the economy from tipping into recession.

Because there is a perceived lag time of around twelve months between the time when a change in Fed policy takes place and when it impacts the economy, engineering such a “soft landing” has proven to be a near-Herculean task, even under less challenging conditions.  Indeed, in the February 2023 Per Stirling Capital Outlook”, we noted that “engineering an economic ‘soft landing’ is highly problematic and rarely achieved”, and we equated it to “landing a 747 on an aircraft carrier”.

In the three months since we published that report, the Fed’s job has only become more difficult, with the advent of a regional banking crisis, and the emergence of an associated “credit crunch”, which will most likely prove to be yet another formidable headwind in the face of the U.S. economy, as banks tighten their lending standards, and credit becomes much more difficult to get.  You can see these tightening credit conditions reflected in the Fed’s Senior Loan Officer Opinion Survey (above).

Of course, it is not just the credit crunch that is impeding the economy.  The Fed is also in the midst of (or has potentially just completed) one of the most aggressive monetary tightening campaigns in U.S. history, money supply (M2) has just contracted for the first time since the 1930s, the Fed is still draining approximately $95 billion per month of liquidity from the economy through its quantitative tightening programs, and there is at least some possibility, albeit hopefully only de minimis, of the U.S. temporarily defaulting on its debt. 

The prospect of a self-imposed default was actually promoted by former President Trump in a recent CNN interview1, and is currently being used as leverage in the debt ceiling negotiations, despite the fact that such a default would likely have disastrous consequences on a global scale.

Ironically, while the government’s failure to raise the debt ceiling would likely be catastrophic, succeeding at raising it may also prove detrimental to the economy, as it would open the door to the Treasury selling over $1 trillion in new debt by the end of the third quarter, which would drain liquidity from the financial system, raise short-term rates and further depress economic growth.  Indeed, Bank of America estimates that it will have the same economic impact as another quarter-point interest rate hike by the Fed2

There is an old expression that “whatever doesn’t kill you makes you stronger”, and the U.S. economy may be proof of that concept, as it has not only managed to avoid recession thus far, but is actually showing signs of accelerating to the upside, despite its many headwinds.

As is illustrated in the above chart, the Atlanta Fed’s estimate of economic growth in the current quarter (green line) has just been upgraded to a remarkable 2.9%, while the “Blue Chip” consensus estimate of Wall Street economists has climbed out of negative territory to a modestly positive reading.

When you consider the enormity of the macroeconomic headwinds facing the economy, it’s pretty remarkable that it is not lying flat on its back, much less accelerating, as it appears to be.  It is, on some levels, without precedent, which Fed Chairman Powell himself acknowledged in the May 3rd post-Fed meeting press conference, when he stated his belief that the economy will avoid recession and that “it’s possible that this time is really different”.3 That quote may send a chill down the spines of more-veteran market observers, who grew up hearing the sage words of Sir John Templeton that “the four most dangerous words in investing are: this time it’s different.”

While we acknowledge the uniqueness of the situation, and the remarkable resilience of the U.S. economy, we certainly do not think that the economy is out of the woods.  Indeed, we remain of the opinion that most of the Fed’s draconian tightening of financial conditions has yet to have its full effect, that the economy is just starting to feel the impact of the emerging credit crunch, and that a U.S. recession is ultimately a matter of “when” rather than “if”. 

This more cautionary outlook is being echoed in the majority of forward-looking indicators.  Whether it is the Conference Board’s Index of Leading Economic Indicators (above), which is giving very strong indications of an impending recession, the most recent Bloomberg Survey of Wall Street economists (below), which assigns a 65% likelihood of recession within the next year, or the New York Fed’s recession model (below), which places the odds of a recession (within the next twelve months) at 68%, almost all of the predictive measures are pointing in the same direction.  

As was just detailed by J.P. Morgan chief market strategist Marko Kolanovic, “Credit markets are not sending a reassuring signal for risk assets as all-in financing costs keep rising, lending standards are tightening, demand for credit is falling aggressively, and U.S. bankruptcy filings [year-to-date] are the highest since 2010”4.  Further, the Conference Board’s May Survey of Chief Executive Officers revealed that 93% of them “are preparing for a U.S. recession over the next 12—18 months.”5 And yet, the economy is actually showing signs of acceleration.  Remarkable!

The economy is like a train sitting at the station.  You can be pretty sure what direction it’s headed in, but you can’t always be sure about the time of departure.  To wit, we see mounting evidence that Chairman Powell is at least partially right, and that there clearly seems to be something out of the ordinary that is supporting the U.S. economy and delaying the highly-anticipated “time of departure” (i.e., recession). 

The explanation may be found in a potentially important May 8th report from the San Francisco Fed that examined the topic of “excess savings”, which is defined as the difference between current, actual savings and the pre-pandemic trend in savings.  In other words, how do current levels of savings compare to what they likely would have been if the pandemic had never happened and the government had not handed out almost $5 trillion of stimulus payments to American households, small businesses, schools, local governments, etc.

As the report summarizes:

“U.S. households built up savings at unprecedented rates following the strong fiscal response and lower consumer spending related to the pandemic. Despite recent rapid drawdowns of those funds, estimates suggest a substantial stock of excess savings remains in the aggregate economy.6

The report went on to say, “there is still a large stock of aggregate excess savings in the economy—some $500 billion. The distribution and allocation of excess savings and wealth across the income distribution suggest that households on average, including those at the lower end of the distribution, continue to have considerably more liquid funds at their disposal compared with the pre-pandemic period. We expect that these excess savings could continue to support consumer spending at least into the fourth quarter of 2023.”

In other words, it appears that consumer spending, which accounts for approximately 70% of total U.S. economic growth, is proving remarkably immune to the economy’s many fierce headwinds, likely because it is still largely being funded by the excess savings that was born out of the government’s massive fiscal spending packages.  Further, this report suggests that this excess savings is sufficient to support consumer spending at least into the third quarter, which could conceivably delay the expected recession into Q4 2023 or even into 2024.

This is yet another reason why we remain very skeptical of the market’s perception that the Federal Reserve is on the verge of pivoting from its current aggressively restrictive policies to aggressively stimulative ones, which you can see in the Fed Funds futures markets, which are predicting 3-4 rate cuts by year-end.  In contrast, rather than the Fed lowering rates, we suspect that they may even need to raise rates at least one more time, as they continue to battle very persistent service sector inflation.

Fed Chairman Powell also disagrees with these market expectations.  As he noted in his May 3rd press conference, “so we on the committee, have a view that inflation is going to come down, not so quickly, but it’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates.”7 That seems pretty clear, and yet the markets continue to price in fairly aggressive rate cuts, starting sometime this summer, and continuing well into 2024 which, from our perspective, would only make sense if the economy enters into a deep recession or some crisis arises that starts to negatively impact the efficient operation of the financial system.

If anything, a closer look at the composition of inflation shows that most of this year’s declines have been in the goods sector, while wage inflation remains troublingly high, and service sector inflation is barely budging from its recent peak. 

Between the very tight labor market, the “stickiness” of services inflation, the recent surge in expectations for future inflation, and the lessons learned forty years ago (the last time that the Fed battled a serious inflation problem), we are hard pressed to imagine a scenario where the Fed would lower interest rates just because overall CPI inflation is receding. 

Since we do not expect rates to come down this year, it is unlikely that market multiples (how much equity investors are willing to pay for each dollar of corporate earnings) will expand, which makes avoiding a recession-driven drop in earnings all-important in the outlook for equities.  Indeed, with domestic equity prices already having returned to what are historically more reasonable valuations, there seems to be a broad consensus that, if earnings recover (as expected), and the Fed starts lowering rates, it would create a very bullish outlook for equities.  However, history suggests that it is not such a linear relationship, and that, as was recently pointed out by analyst Jim Bianco, the equity market reaction ultimately depends on why the Fed is cutting rates. 

If it is because inflation is in retreat, and higher interest rates are no longer needed, that is historically very bullish for stocks.  In contrast, rate cuts by the Fed that are in response to an economic crisis or a sharp economic contraction have historically presaged very challenging equity markets. 

If corporate earnings rebound in the second half of the year as expected (something which we view as overly optimistic), the Fed pauses its rate hikes and the economy manages to avoid a recession, we would view equities as relatively attractive.

However, we believe that a recession changes everything, due to its likely impact on earnings.  Indeed, when the economy enters into a recession, the “error rate” on earnings estimates has historically soared to between 20% and 40%, which we believe would make domestic equities very overvalued. 

Given our expectations for a recession within the next year, we think that it makes sense to emphasize quality in regard to both stock and bond holdings.

That said, high-quality, value-oriented stocks have fallen out of favor this year, and mega-cap growth stocks represent virtually the only segment of the domestic markets that are enjoying a good 2023. 

Unfortunately, these massive growth stocks, while of very high quality, are also extraordinarily expensive (an average of 31 times estimated 2024 earnings, while the S&P 500 trades at only 17.4 times estimated earnings).8 Aside from these aforementioned mega-cap growth stocks, most domestic stocks are really struggling in this environment, and market breadth in the U.S. is actually the worst that it has been since 1999. 

Of note, we do find many international equity markets rather interesting, due to a combination of fairly compelling value and improving fundamentals, and strongly favor larger-capitalization, high-quality stocks, no matter where we are investing.

Higher quality bonds also historically tend to outperform their higher-yielding, lower-rated brethren during recessions, inverted yield curves, and credit crunches (the last two of which we already have). 

It is also worth noting that longer-term securities have historically out-performed under the above conditions, as capital gains have normally more than compensated for the fact that shorter-term securities often offer higher yields in a pre-recessionary environment, as is the case today.

We recommend keeping portfolio quality relatively high and time horizons relatively long, as we suspect that, in the short term, markets have the potential to be highly volatile in either direction.

Advisory services offered through Per Stirling Capital Management, LLC. Brokerage services and securities offered through B. B. Graham & Co., Inc., member of FINRA/SIPC. Per Stirling Capital Management, LLC, and B. B. Graham & Co., Inc., are separate and otherwise unrelated companies.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice.  Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor.
This document may contain forward-looking statements based on Per Stirling Capital Management, LLC’s (hereafter PSCM) expectations and projections about the methods by which it expects to invest.  Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions.  In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  Such statements are not guarantying future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of PSCM’s Investment Advisor Representatives.
Neither asset allocation nor diversification guarantee a profit or protect against a loss in a declining market.  They are methods that can be used to help manage investment risk.
Past performance is no guarantee of future results.  The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted.
The Standard & Poor’s 500 (S&P 500) is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S with each stock’s weight in the index proportionate to its market. It is not an exact list of the top 500 U.S. companies by market capitalization because there are other criteria to be included in the index.
Personal Consumption Expenditures Price Index (PCE) released each month in the Personal Income and Outlays report, reflects changes in the prices of goods and services purchased by consumers in the United States. Quarterly and annual data are included in the GDP release.
The Federal Funds Rate (FFR) is the average interest rate that banks pay for overnight borrowing in the federal funds market.
Real gross domestic product (GDP) is a comprehensive measure of U.S. economic activity. GDP measures the value of the final goods and services produced in the United States (without double counting the intermediate goods and services used up to produce them). Changes in GDP are the most popular indicator of the nation’s overall economic health.
The Bloomberg Economic Surprise Index (ESI) shows the degree to which Street economists either under- or overestimate those top-tier indicators posted in ECO.