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An important read to get an understanding or our position with the markets and economy

July 05, 2023

I admit this post is long but important to read from beginning to end to get an understanding or our position with the markets and economy. 

Better-than-expected Q1 GDP and weekly jobless claims fueled hopes of a “No Landing” economic re-acceleration on Thursday and the S&P 500 rose 0.45%. Those gains were extended on the final day of the quarter thanks to the in-line Core PCE Price Index and the S&P 500 rose 1.23% to finish the first half of the year on new highs, again thanks to stronger than expected growth that’s increasing expectations for no economic slowdown. 

When we started 2023, we and others pointed out that the Fed wouldn’t be the major influence on markets like they were in 2022, and instead economic data would determine Fed policy and drive markets. That’s exactly what happened in the first half of 2023, and it likely will continue in the second half. 

Specifically, economic data in the first half was much better than feared. Growth slowed in the U.S. economy, but only moderately, and none of the major readings (ISM PMIs, Jobs report, Retail Sales, Durable Goods) are screaming a recession is imminent. 

Stocks surged to finish the second quarter at 52-week highs despite a spike in Treasury yields, thanks to strong economic data that revived hopes of a “No Landing” scenario. The S&P 500 rose 2.35% and is up 15.91% YTD. 

Economic data was the driver of the markets last week, as slightly soft European economic data weighed on stocks modestly to start the week, and the S&P 500 fell 0.45%. 

Meanwhile, the labor market saw some softening, but only a little. And with unemployment still well below 4% and jobless claims sub-250k, the labor market remains solidly tight. 

Finally, the lack of any significant economic slowdown helped support corporate earnings, which were stronger than expected in Q1, a fact that helped stocks rally (especially mega-cap tech). 

So, the fact that the S&P 500 rallied in the first half of 2023 shouldn’t be that surprising, given the data. Instead, what was surprising was the size of that rally, which we know was driven primarily by a handful of mega-cap techs that were higher on AI enthusiasm and on the reversal of negative sentiment that saw significant chasing of stocks into the end of the half as markets rallied. 

The impressive resilience of the U.S. economy was better than I thought it’d be, so our preference for more defensive, lower-volatility longs did lag in the first half, not just because of AI enthusiasm in tech, but also because the economy was more resilient than we expected it would be. 

Those factors (better-than-feared data, AI/tech enthusiasm, negative sentiment) also helped markets ignore more Fed rate hikes than expected, higher yields than expected, a regional bank crisis, slowing economic growth and a consistent warning about future growth from the yield curve. 

It’s entirely possible that data stays resilient and stocks extend the rally in the second half of 2023, but the truth is this market today reminds me more and more of 2006 -2007. During that time, there were multiple signals that forecasted an economic slowdown: The Fed had hiked rates significantly, there were pockets of excess in housing (although we had no idea how deep they ran) and the yield curve inverted. 

But the slowdown didn’t come for a while (people first predicted it to start in 2006, but it didn’t arrive until 2008). That delay led many to believe at the time that it wouldn’t come at all (remember “No Landing” from earlier this year? Well, it’s back!). Now, obviously I don’t think we’re going to have another housing crisis or financial crisis. That’s not what I’m saying. 

What I am saying is that twice in the last 23 years I’ve seen clear evidence an economic slowdown was going to happen, only to have it happen later than people thought (1999-2000 and 2006- 2007) and both times that delayed arrival “tricked” people into thinking it wouldn’t come. 

It was those experiences that led me to not be overtly bearish at the start of the year and to advocate remaining long stocks, because growth slowdowns can take much longer to arrive than anyone thinks. Looking forward, perhaps the yield curve is wrong this time. Perhaps the most aggressive rate hike campaign since the 1980s won’t cause a slowdown. Perhaps earnings can hold up. But I’m not sure that outcome is quite as certain as the market performance in 1H ’23 implies. 

To be clear, I’m not hoping for a slowdown. I’m not a bear. I hope the market does keep rallying. I hope there is no slowdown and the S&P 500 closes sharply higher for the year. But it’s not my job to be a cheerleader and say everything’s great because the S&P 500 is up YTD. That’s not why I’m here. 

Instead, it’s our job to stay focused on facts and tell you what’s driving markets and the risk/reward across asset classes and areas we think can outperform (or underperform). Better-than-feared economic data drove markets and pushed stocks higher in the first half of 2023, but the chances of an ultimate slowdown have not declined as much as the S&P 500 would imply—it just hasn’t arrived as early as feared. 

So, as we start the second half of 2023, we remain fully invested holders of stocks, but still wary of an economic slowdown. And unlike the start of 2023, markets do not have low valuations and negative sentiment to cushion any blow. So, while momentum is higher, be aware that if economic data does turn negative (and we’ll be the first to tell you if it does) then there’s no support for this market for at least 10% (or more). 

There wasn’t a lot of economic data last week but what data we got was stronger than expected, and that fueled both a rise in Treasury yields and stocks (especially cyclicals) as investors seemed to re-embrace the “No Landing” economic scenario. 

The key report last week was the Core PCE Price Index out Friday, and it showed continued (small) progress on inflation. The headline PCE Price Index dropped to 3.8% y/y, meeting expectations and hitting the lowest level since April 2021. The Core PCE Price Index slipped to 4.6% y/y vs. (E) 4.7%, a number that’s still much too high (remember it’s supposed to be at 2%) but that is slowly moving in the right direction. And for a stock market that is looking for any excuse to extend the rally, that Core PCE Price index reading was “good enough.” 

As we end the first half of the year, the bottom line on inflation is there’s clearly been progress on bringing it down towards the Fed’s target, and that disinflation has helped fuel the 1H ’23 rally in stocks. However, the past few months have seen little declines in core inflation metrics, which will become increasingly important in the second half of 2023, and those need to continue to decline if the Fed is going to meet market expectations of an additional rate hike and, possibly, second rate hike. 

This Week 

Better-than-feared economic data and a decline in inflation helped fuel the broadening of the rally in June, and given the spike in Treasury yields, economic data will have to stay strong for the market to continue the rally. Given the importance of data for the current rally, this week is important because we get the “Big Three” monthly reports, despite the holiday-shortened week. 

The most important is the jobs report, which comes Friday. 

The next most important reports comes today, via the ISM Manufacturing PMI, and Thursday, via the ISM Services PMI. Again, what’s a “good” number for the market has shifted somewhat with yields rising last week. With Treasury yields at these levels, markets need good data, and that means 1) No further deterioration in either of the PMIs and 2) Ideally, both the manufacturing and services PMI to get back above 50 (the manufacturing PMI has been below 50, signaling contraction, for months). 

Finally, this week is really “jobs week” as we also get JOLTS, ADP and weekly jobless claims on Thursday. All of those reports will be overshadowed by Friday’s monthly jobs report, but they are still important because the totality of the data will tell us if we’re seeing any deterioration in the labor market. 

Bottom line, we remain defensive, with small cap stocks and dividend stocks. I don’t think chasing stocks is ever a good idea and that is what we would be doing if we shifted to large cap technology stocks. My hope is that the economy remains strong, but I don’t want to bet on it. We will keep you informed as to the daily economic and market indicators to determine if anything changes. 

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