· For the week, investors were bailed out on Friday as the December Payroll Report reflected a stable, but slightly weakening labor market along with slower than expected wage growth. This resulted in a rally in both the stock and bond markets which brought them solidly into the green for the start of 2023. Although this sole data point does not a trend make, investors can also point to the weaker than projected Manufacturing and Service Sectors Data from the Institute of Supply Management released earlier this past week. As we have previously noted, at this time we believe that after a total of an additional 50-75 bps (1 bps equals 1/100th of a percent) in interest rates hikes over the next two regularly scheduled meetings (January 31-February 1; March 20-21), the Federal Reserve should pause to assess the impact from prior policy moves.’
An eventual pause in 2023, but no pivot is what investors can expect from Fed policy; that along with a continuance of the harsh rhetoric in regard to the fight against inflation. According to the minutes from the most recent Fed meeting, “participants generally observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2 percent, which was likely to take some time. In view of the persistent and unacceptably high level of inflation, several participants commented that historical experience cautioned against prematurely loosening monetary policy.”
The earnings season is upon us (see below) and investors will pay close attention to the prior quarterly numbers along with projections for the upcoming quarter, specifically as it pertains to revenue, earnings and employee retention. In our opinion, aggregate earnings for the S&P 500 will be reduced as the quarter progresses. The question is as to whether or not this reduction has already been priced into the market. For this reason, over the short-term, expect the financial markets to remain in limbo, directionless, some weeks pushed higher by the same data (economic, corporate, Fed, interest rates) that push it lower during others. That said, as we noted last week, we believe that regardless of the short-term direction of stocks, the landscape over the intermediate-term which we would define as six to twenty-four months is becoming more favorable as the tightening of monetary policy has definitely slowed economic growth which if not too damaging will ultimately pair lacking supply with demand. The bottom line – a new bull market is most likely forming/evolving, but not imminent.
· With the yield on the three-month U.S. Treasury Bill at 4.67% and that of the ten-year Treasury Note at 3.55%, this 112 basis points higher (112/100th of a percent), negative spread is one of the widest on record, signaling at least an economic slowdown if not a recession. Inversions in the relationship between short and longer-dated fixed income securities occur as investors anticipate an economic slowdown and bid up long-term bond prices.
· General Electric (GE) spun off its Healthcare Technologies (GEHC) business on Wednesday with investors receiving one share of GEHC for every share of GE. GE will spin off its energy business during early 2024. The latest moves are an attempt by GE to increase shareholder value through increased efficiency.
· The recent reopening of the Chinese economy has been accompanied by a surge in COVID cases and subsequent fatalities along with new travel restrictions from other countries into and out of China. The progression of the virus has been difficult at best to predict for the medical community as well as for economists in regard to the economic repercussions.
· In our opinion, inflation will fall relatively quickly to the 4%-5% range. However, the next 2%-3% will take a long time, measured in years rather than quarters or months. The result should be meaningful yields on bonds and eventually include, Certificates of Deposits as well as money market accounts. With this in mind and if history is any guide, we consider the period 2010-2020 as more of an aberration rather than the norm with respect to the yields on 10-year US Treasury Notes.
· The onslaught of economic data begins in earnest this coming week. Reports include, on Monday, November Consumer Credit; on Tuesday, November Wholesale Inventories; and on Thursday, the Weekly Report of Initial Claims for Unemployment Insurance and a look at Retail Inflation as represented by the Consumer Price Index.
· The corporate earnings season kicks off this week (see commentary above) and investors will be closely watching the results, to include those of Albertsons (ACI), KB Home (KBH), Taiwan Semiconductor (TSM), Bank of America (BAC), Wells Fargo (WFC), Blackrock (BLK), Citigroup (C), Bank of NY Mellon (BK), Unitedhealth Group (UNH), JP Morgan Chase (JPM), Delta (DAL) and First Republic Bank (FRC).
· LONGER-LASTING ISSUES TO KEEP AT TOP OF MIND
o We are excited about the recent rise in the yield on fixed-income securities, especially U.S. Treasuries. With yields above three and one-half percent all along the curve, should the Fed succeed in reigning in inflation without inflicting too much long-term damage on the economy, real returns on treasuries will turn positive. This will provide conservative investors with a viable alternative to equities and allow them to reduce portfolio risk.
o We liken the aggressive policy of the Fed to rain. The ground (economy) can absorb a couple inches of rain over an extended period of time. However, it cannot absorb it over an hour or two. We believe that after another 0.50% to 0.75% (50-75 bps), it would behoove the Fed to pay more than just lip service to their claim of data dependency or run the risk of cooling off economic growth more than what is needed to quell inflation.
o As of the close of calendar year 2022, over the past decade, the Vanguard Index 500 Fund (VFINX) has posted average annualized returns of 12.25% while its fixed-income counterpart, the Vanguard Total Bond Market Index (VBMFX) has averaged a mere 1.14%. Assuming no compounding or rebalancing, a 60/40 portfolio would have returned 7.81% per year. Assuming that over the next decade the VFINX returns 8.00% per year and given the recent rise in interest rates, the VBMFX 4.00% per year, that same portfolio would return 6.40%, below the historically abnormal returns of a 60/40 portfolio, but most likely well above the returns necessary to provide a reasonable, inflation-adjusted stream of income.
o Unlike the past couple of bear market where investors witnessed a V-shaped bottom, this should be more of a “U,” or a process rather than an event. Not to worry, as we believe this bottom will usher in a new, longer-lasting, more durable bull market, one in which the Fed will not be the center of attraction. However, prior to that, we will need to see inflation ebb and the Fed pivot.
o The yield curve has continued to invert meaningfully. The curve, historically a predictor of an economic slowdown, measures the relationship between like bonds of different maturities. In fact, an inverted yield curve has predicted every recession since 1955. That said, it has also predicted recessions when one did not occur. This past week, the yields on the two- and five-year Treasury Notes were inverted or higher when compared to the ten-year U.S. Treasury Note at 4.24% and 3.69% versus 3.55%. Many market pundits will point to this as evidence of a looming recession. At this time, a technical recession brought about by the Fed raising interest rates is likely, the depths of which are most likely shallow as it will not have been caused by a collapse in the credit markets a la 2007—early 2009.
o Keep in mind that the stock and bond markets are anticipatory in nature, historically moving six to nine months ahead of the confirming data. It is precisely for this reason that investors hoping to “buy when things look better” never get the chance to do so. Unfortunately, by the time the economic data turns for the better, stock prices have already taken this into account. For example, during the pandemic, the stock market bottomed on March 23, 2020, just as the economy was shutting down. Three months later stocks had risen forty percent!
o A component to traditional, longer-lasting bear markets is the emotional strain it places upon the investor. Just as bull markets place pressure on investors sitting on the sidelines, bear markets exert the same force on those that have money in the market. Should the market remain choppy as we believe it will at least throughout the autumn, you can count on a steady drumbeat from talking heads questioning the validity of long-term investing. We have regularly noted that unlike recent pullbacks, the recovery from this one will most likely be more of a process rather than an event and recommend that our clients ignore the short-term and focus on your long-term objectives.
o The Fed has become too important in regulating the economy. Hopefully, when this is over, we can get to a more normalized economy with less overt Fed intervention. Recessions are necessary as they bring back into balance supply and demand. In addition, vis a vis creative destruction, recessions revitalize the economy, positioning it for a new era of growth.
o We continue to monitor the returns of the Vanguard Balanced Index Fund (VBAIX) to illustrate the extent of the selloff even in balanced accounts, including the bond market. VBAIX, somewhat of a proxy for balanced investors fell 16.87% during 2022, as in addition to the pullback in stocks, bonds, which comprise nearly 40% of the portfolio, have been under pressure. For example, the Vanguard Total Bond Market Index Fund (VBMFX) fell 13.26%. In fact, even the Vanguard 2020 (VTWNX), a mutual fund designed for “investors planning to retire or leave the workforce in or within a few years of 2020 (the target year)” fell 14.15%.