“He who is not courageous enough to take risks will accomplish nothing in life.”
The capital markets have a funny way of making the consensus forecasts look foolish. The most popular prediction headed into 2023 was that markets would suffer through a rough first half but rally by year’s end.
After six consecutive calendar years of US large-cap stocks outperforming US small-cap stocks, many investors thought this might be the year for small caps to outshine large caps. Most market observers expected value stocks to beat growth stocks again this year. US stocks were predicted to continue their decade-long dominance over international stocks. Everyone knew that with higher interest rates and still stubborn inflation, bonds were toast — especially below investment-grade securities. And investor enthusiasm for gold had rarely been lower.
But the exact opposite of almost everything that investors anticipated has happened, at least through the first four months of the year.
The economy appears to be on some preset course, hurtling towards recession in the next 12-18 months. S&P 500 companies have experienced two consecutive quarters of negative year-over-year earnings-per-share (EPS) growth. And small cracks are starting to appear in the labor market data. Yet stocks and bonds are admirably climbing the proverbial wall of worry.
For the past three quarters, I have constantly reminded investors that the economy is not the market and vice versa. Now, as markets inch closer to the second half of the year, the economy is slowing, earnings are falling, and the labor market is weakening.
Naturally, investors are on edge and eager to protect their unexpected gains. But one or more of the following five risks could finally produce capital market turmoil in the second half of 2023.
Here’s my take on these five risks as the second half of the year gets underway.
Easy access to credit is the lifeblood of the US economy. And rising interest rates and tighter financial conditions have made credit considerably more difficult to get this year.
For example, the Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices released February 6 revealed tighter lending standards and weaker demand for both consumer and business loans. In addition, the Fed survey reported banks’ expectations for lending standards to tighten, demand to weaken, and loan quality to deteriorate across all loan types for the remainder of the year.
Incredibly, that was before the recent failures of Silicon Valley Bank, Signature Bank, and First Republic Bank. Now, in the aftermath of those failures and amid the ongoing regional banking crisis, there’s a bigger package of data that indicates access to credit has become increasingly more difficult. In the Fed’s latest quarterly SLOOS report from May 8, banks reported tighter lending standards and weaker demand for both consumer and business loans across all categories.
Unsurprisingly, given the regional banking crisis, the Fed focused its special set of survey questions on banks’ expectations for changes in commercial real estate loans. And banks cited an expected deterioration in the credit quality of their loan portfolios and in customers’ collateral values; a reduction in risk tolerance; and concerns about bank funding costs, bank liquidity, and deposit outflows as reasons to expect tighter commercial real estate lending standards over the rest of this year.
The SLOOS data also underscores that credit conditions are deteriorating for commercial and industrial, commercial real estate, residential real estate, home equity lines of credit, auto, credit cards, and other consumer loans. But that’s not all. The latest Federal Reserve Bank of Dallas Banking Conditions Survey and the American Bankers Association’s Credit Conditions Index also point to a weakening credit environment.
This raises the risk of a credit crunch, with many market observers identifying commercial real estate as the likely culprit. At the very least, tightening credit conditions will cool an already slowing economy.
Perhaps the silver lining is that inflation will continue to fall, allowing the Fed to end its tightening cycle. But a growing chorus of market participants think the Fed may have already overdone it. Let’s examine risk #2 to find out.
On May 3, the Fed raised rates for the 10th time since last March, bringing the target fed funds rate to 5-5 ¼ percent, its highest level since August 2007. Despite ongoing challenges in the US banking system and fresh signs that the economy may be slowing, robust job gains and elevated inflation persuaded Fed policymakers to keep tightening in early May. However, subtle but important changes to the FOMC statement language combined with Chairman Powell’s post-meeting press conference remarks hinted that the Fed’s tightening cycle may soon be coming to an end.
Yet bond market yields suggest the Fed may have already tightened too much.
The target fed funds rate of 5-5¼ percent is notably higher than the yields across every maturity on the curve. For example, the target fed funds rate is more than 1% higher than the US 2-year Treasury yield and 1.5% greater than the US 10-year Treasury yield. Concerned that the Fed has overtightened, bond market participants are anticipating a recession, capital market meltdown, or possibly both in the second half of the year. As a result, investors are aggressively pricing in Fed rate cuts by year’s end. Wildly, some investors expect rate cuts as early as July.
Investors should be careful what they wish for when it comes to Fed rate cuts. Historically, during the monetary policy transition period from the last rate hike to the first rate cut, risk assets perform reasonably well. In fact, that may reflect the current investment environment. But when the Fed begins to cut rates, risk assets typically decline. Afterall, the Fed is lowering rates for a reason — usually in response to a recession or capital market breakdown.
The monetary policy risks to the market’s year-to-date rally share a strange connection. On the one hand, if investors are right and the Fed has already tightened too much, when it begins cutting rates, risk assets are likely to fall. On the other hand, with inflation still well above the Fed’s target and a tight labor market, policymakers just might unexpectedly raise rates for an 11th time on June 14.
Neither outcome — rate cuts or a hike — seems particularly good for the short-term outlook for risk assets, especially now that there’s greater competition for investors’ capital from more conservative money market instruments.
In the ultra-low interest rate environment of the past 15 years, there was very little competition for capital. Investors had no choice but to invest in riskier financial assets, spawning the acronym TINA — There Is No Alternative to risky assets. Low rates bolstered the relative attractiveness and valuations of essentially all risky financial assets — stocks, bonds, private equity, real estate, IPOs, SPACs, NFTs, and cryptocurrencies.
Allocating capital to low-yielding money market instruments became an afterthought for investors. That is, until the Fed started aggressively raising interest rates 14 months ago.
Today, certificates of deposit (CDs), money market funds, Treasury Bills, and short term (1-3 years) Treasurys offer yields of 4-5%, more or less. Last year there were precious few places to hide as practically all investments declined and volatility surged. Most investors are expecting a recession, falling earnings, and mounting job losses in the next 12-18 months.
Given last year’s losses and the bleak economic outlook, the perceived safety and stability of money market instruments has become more appealing to investors. Flows into CDs, money market funds, Treasury Bills, and short term Treasurys have soared in the past 12 months. On May 4, the Investment Company Institute (ICI) reported that money market fund assets hit a new record, surpassing $5.3 trillion.
This renewed competition for investor capital has some messy consequences. Significant capital flows into money market instruments saps investor demand for riskier financial assets, putting downward pressure on their valuations. In addition, bank demand deposits continue to yield very little. As a result, depositors are withdrawing their money from savings accounts and placing it in higher-yielding money market funds and Treasury Bills.
According to Strategas Research Partners, commercial bank deposits have fallen by roughly $1 trillion while money market mutual funds have taken in $751 billion since the hiking cycle started.1 A massive decline in demand deposits could exacerbate banking industry challenges by lowering earnings and reducing loan growth. It will be difficult for the economy to gain traction without a healthy banking environment.
For the glass half full crowd, there’s a tremendous amount of capital on the sidelines just waiting for a better opportunity to come back into riskier financial assets. Perhaps once the anticipated recession begins, investors’ appetite for risk assets will return. Until then, investors lie in wait, comfortably collecting stable, reliable income from CDs, money market funds, Treasury Bills, and short-term Treasurys.
There’s a coordinated attempt by market participants to paint the first quarter earnings season as a smashing success. It’s true that with about 85% of S&P 500 companies reporting earnings so far, results have been much better than analysts expected.
According to FactSet, 79% of S&P 500 companies have reported a positive EPS surprise and 75% have reported a positive revenue surprise. Both the number of companies reporting positive EPS surprises and the magnitude of these earnings surprises are above their 10-year averages, making the first quarter earnings season the best performer relative to analyst expectations since the fourth quarter 2021.
Don’t be fooled. Earnings are still falling.
S&P 500 companies are expected to report a decline of 2.2% in year-over-year earnings for the first quarter. This would mark the second straight quarter of declining earnings growth. At 3.9%, S&P 500 companies year-over-year revenue growth will be at its lowest level since the fourth quarter 2020. And profit margins have been contracting for seven consecutive quarters.
Investors cheered Apple’s earnings results because they beat analysts lowered expectations. But Apple reported declining year-over-year revenue growth and a drop in profitability. This is representative of the broader earnings season. Analysts slashed their earnings and revenue estimates and companies easily stepped over the lowered bar. A trick as old as time.
The bottom line for shareholders — owners of these businesses — is that year-over-year earnings declined, on smaller revenues and shrinking profit margins. And next quarter is expected to be worse for S&P 500 companies with analysts forecasting -5.7% year-over-year EPS growth on flat revenues. Remarkably, analysts still expect modestly positive year-over-year earnings and revenue growth for calendar year 2023. Those estimates are likely to get cut in the coming quarters.
With a recession still looming, it’s unlikely that earnings have hit rock bottom. But investors sure are celebrating the first quarter earnings season as if they have. This should leave investors feeling cautious, not confident.
Leave it to the politicians in DC to snatch defeat from the jaws of victory. The US economy expanded moderately in the first quarter. Inflation continues to fall. The labor market hasn’t been this strong in more than 50 years. And stocks and bonds have been rallying since October. Sadly, the US government hit its debt ceiling back in January. The Treasury Department has been using extraordinary measures to pay the federal government’s bills. But, in early May, US Treasury Secretary Janet Yellen, citing a drop in federal tax receipts, warned Congress that the US could fail to meet its debt obligations on June 1, earlier than expected.
Yellen’s warning has set off a mad scramble by Democrats, Republicans, and the Biden administration to raise the debt ceiling. Not to worry. The debt ceiling has been raised 22 times over the past quarter century and more than 100 times since World War II. It will be raised again. It’s the process of raising it and some of the probable compromises that should frighten investors.
President Joe Biden met with top congressional leaders on May 9 to jumpstart negotiations. On the surface, it didn’t appear that much progress was made, with Biden and the Democrats sticking to their stance that the debt ceiling should be raised cleanly without any corresponding spending cuts. Meanwhile, House Speaker Kevin McCarthy and Republicans continue to insist that spending cuts be included as part of any agreement to increase the debt ceiling. An apparent stalemate. However, both sides instructed their staffs to continue negotiations
We’ve seen wild headlines about Biden using the 14th Amendment to the Constitution to bypass Congressional action on the debt ceiling and, even crazier, the creation of a $1 trillion platinum coin to avert debt ceiling disaster. Ignore the noise. Politicians may bring investors to the abyss, they may even get to peak over the edge, but fear not, policymakers won’t allow us to tumble into the chasm.
Yellen hinted on May 13 during a meeting of G-7 finance ministers that default would be avoided. And on May 15 Biden said he was optimistic a deal would be reached, although McCarthy described the sides as still “far apart.” Biden and McCarthy will meet again on May 16.
The likely outcome is a short-term debt ceiling increase combined with the outlines of a broader spending agreement. Politicians doing what they do best — kicking the can down the road when what we need is a spending agreement that would also facilitate a debt ceiling increase the next go around. This is a complex negotiation. Time is short and the stakes are high.
According to Strategas Research Partners, there could be bigger risks after the debt ceiling is raised. The economy is slowing, and counterintuitively, liquidity declines when the debt ceiling is raised. Additionally, whenever government spending is above its long-term averages, as it was in the mid-eighties, mid-nineties, and around 2010 in the aftermath of the Global Financial Crisis, the debt ceiling is often used as a catalyst for a reduction in government spending. Nearly all of the equity market decline in 2011 happened after President Obama and Speaker Boehner reached a debt ceiling deal.2
Massive government spending to combat the negative impacts of the pandemic temporarily boosted economic growth, fueled inflation, and left government spending significantly above its long-term average. An agreement to reduce spending by at least a $1 trillion over the next decade reached as part of the debt ceiling negotiations might further slow economic growth and reduce inflation.
At the beginning of the year, the consensus forecast was for both the economy and markets to tumble in the first half but rebound by year’s end. Like so many other predictions from the start of the year, almost the exact opposite has happened. The economy modestly expanded in the first quarter and markets are off to a surprisingly strong start.
But growing recession fears, declining corporate earnings, and tiny fissures in the labor market have investors feeling restless about their unexpected good fortune.
It’s especially critical now that investors remember that the economy is not the market and vice versa. As the old market adage claims, in the short run, the market is a voting machine, but in the long run, it is a weighing machine. Short-term sentiment determines prices and moves markets, but over the long term, fundamentals determine value.
A looming credit crunch in the aftermath of the regional banking crisis. Bond market yields that suggest that the Fed may have already overtightened. Positive real interest rates that ended the TINA era and increased the competition for capital. Earnings that are falling on shrinking revenues and contracting margins. And the ugly process of the debt ceiling debate. All this points to more stress for investors. Meanwhile, other risks likely lurk just beneath the surface.
So, what should investors do to sooth their nerves in this complex investment environment?
With an unusually wide range of possible outcomes, investors should embrace the benefits of diversification. This also helps portfolio performance when the unexpected happens — like in the first four months of 2023.
Money market instruments such as CDs, money market funds, Treasury Bills, and short term Treasurys haven’t offered yields at these levels in 15 years or more. Investors should allocate capital to money market instruments prudently and try not to leave any money on the table with their choices.
Finally, investors should seek to courageously put money to work in inexpensive investments that benefit in the early stages of an economic recovery — such as value stocks, dividend growers, international stocks, small caps, and early-stage cyclical sectors.
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1 “Headwinds To Persist For Financials,” The Daily Macro, Strategas Research, May 9, 2023.
2 "Debt Ceiling Negotiation Have Started, Now Comes the Hard Part,” Strategas Research Partners, May 10, 2023.
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