We always experience times in markets where buy or sell opinions are debated daily. Seldom do those possibilities diverge as much as we are seeing today. Economic pessimism seems rampant, driven by politics, global conflict, rising interest rates, and inflation. However, U.S. economic resilience has been remarkable despite substantial obstacles. We see some pockets of opportunity in markets and will make adjustments accordingly.
Debt Limit: If Congress does not increase the debt limit in time, stock and bond markets will lock up. The economy will grind to a halt almost immediately. Prices will drop dramatically as virtually all liquidity will cease to exist. Fortunately, most of Congress realize the consequences and will work to ensure this does not happen. It is likely to require a bi-partisan vote as there are politicians on both ends of the spectrum who do not seem to care (at least rhetorically) about their scorched earth pursuits. We expect any decision to go to the deadline, increasing short-term market volatility.
Interest Rates: The Federal Reserve is committed to bringing down inflation. Although the inflation rate has calmed considerably, there is a concern it has not dropped enough, particularly with a still tight labor market. Short-term (less than six months) rates have risen over the past month and may also reflect risks around the debt limit debate. Any indication of stopping rate increases is likely to be bullish for the stock market (short-term), and any sign of continuing increases will likely cause stocks to sell off.
Bank Failures: Any bank with a run (too many depositors withdrawing deposits within a very short period) will “fail”, particularly in a rising interest rate environment. We previously commented on the dynamics which caused the SVB default. The economy cannot expand if credit is contracting due to problems in the banking sector. We feel this is a primary concern and have worked to reduce exposure to the financial sector, which generally would be doing well in an increasing interest rate environment.
Technology: This is a high-risk opportunity, given current stock valuations. Earnings and revenues of large technology companies have come in higher than (reduced) expectations. (Apple reports earnings today). Even across the S&P 500 companies, earnings have beaten analyst expectations in roughly 80% of companies. Microsoft and Apple represent 15% of the value of the S&P 500 (an extraordinary concentration in what is considered a diversified fund), and those two stocks are responsible for almost 40% of the gain in the S&P 500 fund year to date. However, on the NASDAQ exchange, home to many technology companies, more stocks are hitting new 52-week lows than new highs. The chart below shows even with great returns year-to-date, Apple and the NASDAQ index (as represented by the ETF symbol QQQ) are still appreciably below their highs reached in January 2022. If the Federal Reserve truly stops hiking interest rates, we feel there is enough support for further price appreciation.
International: European firms have reported better earnings growth than U.S. companies over the last three quarters. A weakening dollar and increasing spread between U.S. and foreign company values may provide good investment opportunities. If earnings continue to hold up, it is reasonable to increase the international allocation. We also think the dollar will continue to weaken versus major currencies. The chart below shows the changing trends.
Homebuilders: This is perhaps the most interesting sub-sector. Experiencing very high cancellation rates in the initial phase of interest rate increases, homebuilders are now seeing high demand. As a result, cancellation rates have dropped dramatically. Lower or stable interest rates provide a favorable economic environment, along with demographically driven demand, making this subsector very attractive.
Financials: It is too early to get excited about re-investing in the financial sector, although it certainly appears the sell-off was too broad and overdone. For example, PNC, which was in the running to take over Republic Bank at the end of last week, dropped about 10% over the previous two trading days. It has fallen over 30% from its 2023 high in January. Nevertheless, financials are a high dividend-paying sector and should recover from current prices if the banking crisis is contained.
Energy: This sector has been very weak, particularly since mid-April. The threat of recession, as well as potential slower growth in China, is affecting stock prices. However, it is also possible this is a short-term move. Fundamentals, which include tightening crude oil inventories, may mean we are near lows. We are nearing an inflection point on whether to decrease exposure.
Listening to Chairman Powell this week is a lesson on uncertainty. In this environment, we want to focus primarily on generating income while looking for selefct growth opportunities. The focus is generally shorter-term because the risk of a market drop, driven by recession and poor corporate earnings, seems more significant than the possibility of rapidly rising stock prices. And as we wrote in our previous communication, the forward returns for fixed income are attractive, with far less risk (in our opinion).
Charts from Optuma.com and YCharts