Many of you are busy completing your mid-year assessments, comparing your accomplishments to date against the goals you set back in January. We decided to do a little checking in with the economy, whose tasks are to stabilize and grow, to see how it is faring now that the year’s halfway point is here.
For today’s performance evaluation, we’re separating out the long-term and short-term perspectives. We haven’t been feeling terribly optimistic about the economy’s long-term prospects, but there are a few glimmers of hope.
Let’s start with the fact that we are facing a banking crisis, as deposit outflows from US institutions continue. In the year’s first quarter, total US deposits declined by 2.5% – or a whopping $472B – the largest outflows on record since the FDIC began collecting data on this in 1984. The decline is from uninsured funds at US banks and does not bode well for weaker banks. Banks have been utilizing the Federal Reserve’s emergency borrowing window at a frantic pace in the last few months. The silver lining: more bank failures will lead to a tightening of lending in the market, which would also help tame inflation.
What’s new in the rate hike cycle? The Federal Open Market Committee (FOMC) did not raise the federal funds rate at the June 2023 meeting, but that doesn’t mean the rate hike cycle is over. Estimates suggest at least two more rate increases of 25 basis points each before the end of the year.
There are a few data points that imply those rate hikes are coming. First, unemployment remains low at 3.7% through the end of May 2023. Employers added 339,000 jobs in May and inflation, as measured by Core Personal Consumption Expenditures, remains stubbornly elevated. (Interestingly, overall inflation rose at a 4% annual rate in May – while still elevated, this was the lowest it has been in 2 years.)
These rate hikes, if they go through, do not bode well for real estate operators, zombie companies that will be unable to service the interest payments on their debt, and the industrial sector. And commercial real estate operators are already suffering as they default on office spaces in large cities across the US. According to a Bloomberg report, the number of distressed assets increased by 10% in Q1 of 2023. Operators are unable to refinance due to tightening credit conditions as vacancy rates continue to rise.
To round out our mid-year review of the long-term outlook, we’ll turn our attention to the US Treasury Yield Curve, which is currently inverted (meaning short-term interest rates are higher than long-term interest rates.) This unusual occurrence has historically been a very reliable indicator of an upcoming economic recession. Since World War II, every yield curve inversion has been followed by a recession in the following 6-18 months.
The latest data from the Commodity Futures Trading Commission (CFTC) shows that in the week through June 13 funds increased their record net short positions in two-year Treasuries futures to more than 1 million contracts, and reduced their net short position in the 10-year space for a second week. This implies professional investors are betting on an even deeper US yield curve inversion.
In the short-term outlook, data from Bloomberg shows stock market outflows from money market funds for the second consecutive week – these were mostly institutional investors repositioning while retail funds continued to have a ninth straight week of inflows. Retail investors’ fear of missing out (FOMO) typically happens at market tops, causing the volatility in call options to be higher than the volatility in put options. Call option volume also continues to be higher compared to put options. Market makers selling these call options need to buy stock to hedge their positions, thereby creating a loop of increasing prices.
A modest decline in stock prices this past week was accompanied by a VIX that also declined, suggesting that the market is without fear and all expectations are for the rally to continue. While the Relative Strength Index in the S&P 500 was extremely elevated and suggesting a correction, declines in the past week relieved this overbought condition.
We are cautiously optimistic in the short-term, investing in value dividend stocks in healthcare, tech, and consumer staples. The market technicals are bullish and retail investors are recklessly crowding in. However, US equities are overvalued but could continue pushing higher on lower summer volume.
To summarize, it feels like all is well for now but there are dark clouds on the horizon!
