October Private Client Letter
/Winning by Not Losing
Over the past several months I have warned of potential weakness in equities following a rally earlier in the year that saw the S&P 500 rise by as much as 20% from the beginning of the year. It appeared that valuations were being stretched as the market breadth narrowed. In other words, equity prices were rising faster than corporate earnings and the gains had become dominated by only a handful of mega cap names in the communication and information technology sectors.
It is interesting to observe that most U.S. stocks are having a challenging year. If we look at the equal weighted S&P 500 index (as opposed to the value weighted index which places great emphasis on the largest names), we see a stock market that is down for the year through the first three quarters. Only a handful of very large technology companies, such as Apple, Microsoft, and Nvidia, have enjoyed big gains from their perceived generative artificial intelligence exposure. The rest of the market has largely traded flat for the year.
As the S&P 500 rose above 4,500, we rebalanced our portfolio strategies away from pure beta (the value weighted index); which simply means that we intentionally reduced exposure to those mega cap technology names that we believed had become the most overvalued. Simultaneously, we added duration to our fixed income strategies to capture higher yield-to-maturity levels in response to the 10-year Treasury yields crossing 4.5%.
The S&P 500 peaked in late July and has subsequently dropped by about 6.5% into early October. While the Fed elected to not raise the fed funds rate in September, interest rates have been rising steadily since their lows in April. The 10-year Treasury yield that was 3.28% at that time, now trades at nearly 4.7% (a level not seen since 2007).
Our base case continues to see a recession developing in early 2024 and our rebalancing activities have reflected this perspective with our portfolios becoming incrementally more defensive.
The challenges our economy now face are numerous. Tailwinds have shifted to headwinds, and we continue to believe risk is asymmetric to the downside. This simply means that we believe more could go wrong at this point in time, than could go right. While a last-minute agreement in Congress has averted another government shutdown, the national debt recently crossed over $33 trillion causing many commentators, including the likes of Ray Dalio and Michael Peterson, to again warn of a looming debt crisis.
U.S. debt levels have ballooned in recent years, especially after a roughly 50% increase in federal spending between fiscal 2019 and fiscal 2021, according to the U.S. Department of the Treasury.
The latest findings from the Congressional Budget Office indicate that the national debt will nearly double in size over the next three decades. At the end of 2022, the national debt grew to about 97% of gross domestic product. Under current law, that figure is expected to skyrocket to 181% at the end of 2053 — a dangerous debt burden that will far exceed any previous level.
Inflation has been the central problem for policy makers since it began to spike in 2021. While the rate of inflation has declined from a 40 year high in mid-2022, it appears to have reversed higher over the past several months. This recent pressure in the inflation data coincides with a surge in the price of oil (WTI crude) from $68 per barrel in June to over $93 by the end of September. Supply-side dynamics relative to the price of oil (and gasoline) are likely to persist as the OPEC nations continue to limit production.
Commodities experts at a number of investment banks, including Goldman Sachs and Wells Fargo, argue that the rise in oil prices is just the beginning of a commodity “super cycle” that could bring new upward pressure on inflation. Some analysts are even projecting the price of oil could soon cross $100 per barrel.
Throughout U.S. history, oil price shocks have routinely helped to spark recessions. High oil prices increase costs for a broad range of companies and weigh on consumers’ budgets, which can lead to rising inflation and falling consumer spending. For its part, the Fed appears committed to further interest rate hikes should inflation fail to reach their target level of 2%.
Inflation has already dealt considerable hardship to the U.S. consumer with cumulative aggregate prices now 17% higher than they were in January of 2021. Personal income has not kept pace with this level of inflation and consumers are now spending considerably more on what they need (or they are bringing home much less in terms of goods and services).
The final quarter of 2023 is likely to bring many puzzling crosscurrents to the economy and the capital markets. We see economic activity slowing considerably from an expected strong showing in the third quarter (some Q3 estimates now calling for growth of 4% or more). The long list of current problems includes the current UAW strike, the resumption of student loan payments following the Supreme Court’s striking down President Biden’s effort to forgive student loans, mortgage rates approaching 8%, and the ongoing issues in the commercial real estate market.
The potential negative impact of these concerns has begun to appear in earnings expectations. Following adjustments higher in August and September, earnings revisions have turned negative again for both 2023 and 2024 (Crossmark).
All of this points to a slowdown in economic activity triggering an eventual recession. It is important to note however, the next recession is unlikely to be as devasting as the ones in 2008-09 or 2020. Still, our view remains that a relatively short and potentially shallow recession is on the way.
Accordingly, we will maintain a neutral “winning by not losing” stance with regard to portfolio strategy and capitalize on future opportunities to become more defensive as the storm clouds continue to gather. Eventually the economic cycle will produce attractive opportunities to overweight equities. We intend to be patient and prepared for when this occurs.
As always, thank you for your continued confidence in our abilities to help you navigate the many challenges associated with growing and protecting your wealth.
John E. Chapman
Chief Executive Officer
Chief Investment Strategist
