Quarterly CIO Letter: Second Quarter 2023
Every investment decision we make is based on the amount of risk we are taking for the potential reward we are expecting. Today, we do not think the risk versus reward profile in most risk assets is attractive.
Short-term treasuries are yielding close to 5.5% on an annualized basis, making them a compelling place to wait until other areas of the market become more attractive. This raised the threshold of returns needed to take additional risk beyond the risk-free rate.
We believe yields will be higher for longer, implying that a rerating should occur in the markets to adjust to this new reality.
Demographics explain a lot of what is happening today in the labor market and the lasting inflationary pressures.
The Second Quarter Recap
The first half of 2023 proved incredibly strong. A volatile first quarter gave way to decisive strength in the second. The market rally was remarkably narrow, concentrated in a few big names mostly related to artificial intelligence (AI), until mid-June when the strength began to broaden. Internationally, Europe, Japan and select Emerging Markets also experienced a stellar first half of the year.
The growth factor excelled in the second quarter, largely due to the AI hype. While we believe in AI as a theme, we believe the majority of earnings benefits will take years to realize and expectations currently baked into these stocks leave them ripe for disappointment. Broadly, first quarter earnings growth and guidance rebounded better than expected and economic growth proved more resilient than anticipated. Seventy seven percent of companies beat expectations, the most since the first quarter of 2022. Guidance led analysts to move the trough in earnings from Q2 2023 back to Q4 2022, signaling the pain was behind the market. Chart 1 shows first quarter earnings strength has been extrapolated out in forecasts. These earnings forecasts will be difficult to achieve given that they are dependent on increasing margins. However, stripping out the pandemic, margins remain near all-time highs (Chart 3).
Inflation continued to moderate in the second quarter, signaling progress, though not enough to declare victory. Core inflation is still elevated, and it is not coming down as quickly as central banks would like. The work to get inflation down to 2% will be difficult. June’s decision not to hike rates brought more bets the Federal Reserve, which raised rates 500 basis points in 15 months, was at the end of their hiking cycle. The decision was the result of a convergence of headwinds creating uncertainty—tighter lending stemming from the crisis, a flood of issuances from the Treasury coming to market, shrinking money supply, and higher rates hitting companies with credit coming due (particularly in the commercial real estate sector). The pause (skip) was wise, in our view, giving them time to assess how much impact tightening has had on the economy as well as monitor for spillovers from the March banking turmoil. We agree that most of the hiking cycle is in the rear-view mirror; however, we believe bets on rate cuts are misguided and the only way that would occur is if growth slowed severely. We do expect a hike at next week’s meeting.
This has been a difficult investment environment because the risks are widely known, some economic data has been distorted by the pandemic, many investors are bearish, and plenty of cash remains on the sidelines. Valuations are a terrible short-term timing tool and can stay elevated for extended periods, but usually prevail over the long run. We continue to look for a washout in our economic indicators which typically signal that point of capitulation where the cycle resets. It is difficult to experience a healthy cycle without that washout of excesses, especially when inflation exists. Absent that reset, inflationary pressures could reemerge with any rebound in growth, limiting the upside.
There is a heightened level of uncertainty and risk in the current environment. Over the past two decades, investors had to be in risk assets to generate any sort of return. The environment was referred to as TINA, There Is No Alternative. Today, the 3-month treasury yield is above the S&P 500 earnings yield (Chart 2) for the first time in two decades. We are comfortable staying very short-term in treasuries, maintaining dry powder to give us the flexibility to capitalize on volatility. In our view, this was the biggest change in the second quarter.
Chart 2
Where Do We Go From Here?
Our leading indicators are mixed, but the balance suggests weakness ahead. Elevated economic uncertainty increases caution among consumers, businesses, and banks. We are also seeing evidence that companies are having more difficulty passing on higher prices to consumers. The small business optimism survey remains extremely low, with their sales outlook slowing, and wage pressures continuing. This is a less positive picture for margins going forward.
A paper published in June in the Finance and Economics Discussion Series at the Federal Reserve Board titled “End of an era: The coming long-run slowdown in corporate profit growth and stock returns” by Michael Smolyanksy argues just that.[1] His data estimates that over 40% of real growth in corporate profits from 1989 to 2019 was attributable to lower interest expense and corporate tax rates. According to his data, in 1989 interest and tax expenses accounted for 54% of aggregate earnings before taxes and interest, but by 2019 it was 27%. The data he used in his research finds that all of the expansion in price-to-earnings multiple (how many dollars the market is willing to pay for each dollar of earnings) is attributable to the decline in the risk-free rate. While he does not include share buybacks in the paper, intuitively what he is saying makes sense.
He shares our view that these factors are unlikely to continue. Corporate profit margins (Chart 3) are still at all-time highs absent the lift they got post-pandemic. Valuations are also extremely elevated. A de-rating of multiples and lower margins and earnings growth is definitely not on the market’s radar.
Tighter lending standards typically precede decreased lending activity and a recession. Lending standards for consumers and businesses have been tightening for several quarters and hit levels that typically precede recessions before the bank failures even began (Chart 4). Banks tighten lending standards when they worry about credit risks, becoming more selective on the loans they make. Smaller and medium-sized banks account for a sizable portion of commercial and industrial lending as well as consumer lending. Regional banks also have a fair amount of commercial real estate loans which could add additional stress.
Higher capital requirements and increased default rates could tighten lending standards further. Thus far, the risk and pain has mostly been limited to interest rate risk and we expect credit risk to be the next leg. To us, this is an unfortunate, but necessary pain to allow the economy to wring out the excesses and prepare for a healthy new cycle. There are signs the next leg may be beginning. According to data from S&P Global, the first half of the year contained the highest number of corporate bankruptcies since 2010. There were almost as many in the first half of 2023 as all of2022.[2] There is a big debt maturity wall coming due in the next two years for junk bonds. This could push many companies to the brink as they are forced to borrow at higher rates if they want to sustain their businesses. Additionally, there could be a squeeze on market liquidity in the second half of the year as the Treasury rebuilds its cash at the Fed.
Twenty-seven million Americans are set to owe monthly payments on student debt starting this fall.[3] $1.1 trillion in student loans are in forbearance. The restart of payments will pull money out of the economy that has gone to consumption over the last three years. These borrowers are also the ones increasing credit card debt and auto loan debt to historically high levels (Charts 5&6). While delinquency rates on the consumer side remain low, there is a notable tick up in credit card delinquencies and those 90 days or more delinquent on auto loans.
Chart 5 Chart 6 Source: TransUnion
There are also signs the labor market may be beginning to weaken. Most of the labor market data lags the overall economic cycle. However, jobless claims is a leading indicator and has begun to tick up. Weekly hours worked and overtime hours in manufacturing are leading indicators and have shown a significant slowdown. Labor market tightness is responsible for much of the stickiness in inflation. We believe slack needs to be created in the labor market for the Fed to achieve their 2% inflation target.
Looking under the hood, the labor force participation rate is actually growing above trend. Most age cohorts are participating in the labor force at a higher rate than they have historically. The labor force participation rate by age cohort actually suggests wage growth has been enough to pull people off the sidelines and into the workforce. Because the labor force participation rate includes those above 65, it is just the demographic shift that has caused a permanent drop in the participation rate (Chart 7). Those 65 and older have much lower participation rates than those in their prime working ages. This implies there really isn’t any slack in the labor market, and this will be difficult to solve. We believe the natural rate of unemployment should be lower going forward. Longer-term, automation (a secular theme we have exposure to) will help bridge this demographic gap.
We are moving towards a desynchronization in monetary policy and economic cycles. Some areas of the world are showing their resilience to tighter financial conditions better than others. China’s inflation is more under control than most of the rest of the world, however its economy is showing cracks as it struggles with its new growth model. They are working on ways to stimulate the economy. We believe that the US is closer to the end of its rate hiking cycle than both the Bank of England (BOE) and the European Central Bank (ECB). The Bank of Japan (BOJ) remains the only large central bank that is still engaging in easing. They have a moment to kill deflation, and they will go down swinging. We are watching for when/if the BoJ lifts yield curve controls as this would have a massive impact on global markets, and more specifically on US Treasuries which the Japanese own a whole boatload of.
Inflation is that sticking point that is the huge risk. Central banks are mandated to get inflation under control. Thus far that is really the only piece of their mandate they have needed to pay attention to. However, going forward price stability and employment will be more important. Europe is seeing a major slowdown in economic activity. Will central banks have the resolve to stick with the inflation fight?
How We Are Positioned in the Current Environment
Everything we do is centered on the risk we are taking versus the reward we are anticipating. Uncertainty remains elevated, both from a geopolitical and economic perspective, and we do not believe this is being reflected in valuations. Our view is that the risk remains tilted towards the downside. Inflation is still an issue, central banks around the world are continuing to tighten, China growth is disappointing expectations, and there are risks to financial stability in places.
We wrote the following last quarter: “Treasury yields are also an input for many investors’ equity valuation models. When yields are low, investors are willing to pay more for stocks. When yields rise, theoretically, the opposite occurs.” This is the premise of our risk versus reward call. We believe yields are going to be higher for longer, which suggests a re-rating should occur within the equity market to adjust to this new reality.
The yield curve remains inverted. However, corporate credit spreads continue to tighten, signaling a “nothing to see here” environment. While spreads can blow out quickly, they are a leading indicator of pain to come in the equity market and we are not seeing that signal outside of the lowest credit ratings. We are using this opportunity to decrease our corporate bond exposure given the very narrow spread to treasuries. When looking at sentiment, we are beginning to see signs retail investor bullish sentiment is back. We use this as a contrarian signal and will be watching closely.
We are entering another earnings season. Despite the deterioration in earnings that has already been experienced, expectations for future earnings remain robust relative to the headwinds of slower growth, less stimulus, and less pricing power. The significant pre-earnings rally has left the market priced for perfection. In our view, current valuations are only justifiable if the market believes the Fed will thread the needle and they are able to cut rates. With the market valued for this best-case scenario, there is plenty of room for disappointment. We believe the hiking cycle is only likely to reverse if the economy slows substantially enough for inflation to be squeezed out of the system. That is not a positive scenario for stocks or earnings.
Typically, during an earnings contraction, the multiple investors are willing to pay begins to fall, but that is not happening this time around. Can the markets continue to stay disconnected from reality in the second half? We will see, but given short-term treasuries are paying close to 5.5%, we would prefer not to take the risk. We are sitting comfortably, waiting for the storm to pass. Our indicators are continuing to keep us near the bottom end of our equity range. They are signaling higher risk normal risk, lower than normal returns, and an abysmal batting average over treasury bills. With this much uncertainty, we are hesitant to take additional risk.
We remain at the low end of our equity range and are tilted towards defensive, quality, value-oriented and inflation beneficiary parts of the market. We would be more comfortable with earnings expectations if the market wasn’t also paying so much for each dollar of expected earnings. We expect volatility in both the equity and the fixed income markets to persist.
Opportunities do exist today. We began closing our underweights to both small caps and international equities in the first half of the year. From our perspective these areas were more adequately pricing in economic realities (Chart 8), and we were coming from significant underweight allocations that were no longer warranted. We believe it is prudent to continue to slowly close those underweights though we are waiting for a pullback in many of these markets. Given that small caps are more vulnerable to a recession than large caps it is early to buy. However, active management with a tilt towards healthy balance sheets and defensive characteristics in this area will help identify interesting opportunities. Our hybrid approach gives us the flexibility to increase exposure to active management where we believe it pays to be active. Outside of the US we continue to look for opportunities because valuations are more compelling on both a relative and absolute basis. Some Emerging Markets have inflation under control better and a weaker dollar could also help international investments. The slowdown in Europe has kept us from adding there.
Part of building wealth over the long-term is protecting capital when risks are elevated. In today’s environment we believe it is prudent to remain defensively positioned. We are taking risks selectively where we think it is appropriate. We remain disciplined with clients’ long-term goals in mind and continue to customize client portfolios to suit their individual needs and risk tolerances. Especially in this environment, it is of paramount importance to only take the amount of risk necessary to achieve client objectives, stay diversified, and avoid being overweight to expensive areas of the market where the risks are not in your favor. We have a pile of dry powder, earning over 5% on the sidelines, to take advantage of opportunities that emerge from volatility.
As always, please reach out with any questions.
Kasey
[1] Smolyansky, M. (June 2023). End of an era: The coming long-run slowdown in corporate profit growth and stock returns. Finance & Economics Discussion Series: Federal Reserve Board, Washington, D.C.
[2] https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/54-new-us-corporate-bankruptcies-take-h1-tally-to-highest-level-since-2010-76444770
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