Narrative Adjustment
Weekender
March 4, 2023
Good morning and welcome to the Weekender for Saturday, March 4, 2023. US markets, as measured by the S&P 500, gained 1.9% on the week. A strong gain. Despite useful economic and market data from the past week, markets were really interested in next week’s employment data. If labor markets show continued strength, the Fed will be forced into a more aggressive interest rate stance which will handicap fixed income and equity markets for a while.
S&P 500 Index Levels and Price-to-Earnings Ratios
(Source: Bloomberg)
Last year’s equity market drawdowns set the stage for the powerful rally in January. Markets mostly kept time in February. Valuations, although lower than they have been in the last four years, remain elevated compared to the average PE ratio of 16.7.
The path forward from here is murky. A few insights may shed light on where we think the economy and financial markets are headed. First, and most important, the labor market is strong. Without significant weakening in the labor market a deep recession is unlikely. Second, while supply and demand for some products remains out of balance, a general mending is oc-
curring in global supply chains. Inventories are likely to be back to normal by the end of the year resulting in lower sustainable inflation and a return of stable corporate operating and profit margins. This will also take a year or so. But it will happen. Third, over the near term, corporate profits will fall, creating great opportunities to buy quality companies at a discount. Be ready. Fourth, the pandemic and post-pandemic consumption patterns will change. We will not go back to 2019 patterns. Online purchases will continue. Workers go back to the office. Household formation will accelerate. Retrenchment and thrift will be en vogue. Fifth, inflation will come in-line and interest rates will fall. But they won’t come back to where they were before the pandemic. The Goldilocks era is over.
In this Weekender, we will highlight some of the market moving data points from last week, summarize key economic issues, and provide context for the moves in countries, instruments, sectors, and themes. We won’t have a one more thing segment this week. Be sure to consult a qualified financial advisor prior to making investment decisions.
Market Narrative Rates
on two- and 10-year treasuries were higher for the sixth straight week. Bond yields haven’t been this close to the S&P 500’s earnings yield for more than a decade. Most traders and investors believe that treasury yields are likely to return to their pre-pandemic level - a reasonable assumption so long as inflation reverts to the Federal Reserve’s 2.0% target. However, if inflation remains persistent rates will stay higher for longer. We believe higher for longer is likely to last for a couple of years.
In the graph below, the blue line is the yield on riskfree US government bonds. The gold line is the earnings yield of the S&P 500 equity index.
US Two-Year Yield and S&P 500 Earnings Yield
January 3, 2000 - March 3, 2023
(Source: Bloomberg and AIA Research)
We believe, at their current levels, bonds are a bargain, especially compared to the much higher risk equity alternative. We also expect that as fixed income yields persist and equity earnings soften, investors will increasingly reallocate cash to bonds.
At present, bond markets are signaling a dire economic and market environment on the horizon. Interest rate inversions have historically been a good indicator of approaching recession. As of Friday, the rate inversion between the US 10-year government bond and the two-year equivalent is the most inverted it has been since 1981. The bond market is pessimistic
US 10 - 2 Treasury Yield Inversion
January 1980 - March 2023
(Source: Bloomberg)
about economic growth and stability over the coming quarters, but we believe the bond market may be overemphasizing the worst-case scenario.
In a few conversations with clients and Weekender subscribers last week, the question was raised about the relative importance of our focus on decisions being made by the Federal Reserve. As the preeminent arbiter of interest rates in the global marketplace, the Federal Reserve’s actions are critical to both economic performance and financial market functioning. In addition, since the Credit Crisis, the Federal Reserve has been a heavy market participant, providing unprecedented liquidity and upward pressure on financial markets, generally, by openly purchasing securities. Globally, central banks from around the world have been following the example of the Fed.
In the graph below, the US Federal Reserve’s balance sheet relative to the S&P 500’s level (the gold line and left axis), increased dramatically going into the pandemic which had the effect of injecting excess liquidity into equity markets and pushing valuations to extreme levels (the blue line and right axis). In 2022, the Fed began shrinking its balance sheet resulting in a financial market valuation reset. We believe it is difficult to overstate how supportive the Fed has been to financial markets. As this support wanes, investment instruments will gradually be forced to bear the weight of their unique fundamentals.
Economic Summary
Our economic summary will be dedicated exclusively to data released by The Institute for Supply Management last week. The data set is referred to as the Purchasing Managers Index (PMI). Readings above 50 suggest expansion while those below 50 portend a degree of contraction. We will look at the general PMI for manufacturing and services in addition to another reading for prices paid and one for new orders.
Services, which account for 77.6% of economic output, showed renewed consistent signs of strength after dipping into contraction in January. Manufacturing also showed a slight uptick from last month although still in contraction territory. The point. Neither PMI data sets are reflective of an economy dealing with deep recession in the offing. Instead, they are more reminiscent of an economy working off its excess inventory.
Services (Gold) and Manufacturing (Blue) PMI
January 2015 - Feburary 2023
(Source: Institute of Supply Management)
From an inflationary perspective, the PMI data showed that prices in the service sector continue to be high and those in the manufacturing space, after contracting for a couple months, have rebounded. While pricing strength in services is not a surprise, the turnaround in manufacturing is. We had expected robust inventories to lead to a consistent period of lower prices in manufacturing. A return to pricing strength
suggests that supply chain issues may be moderating faster than expected.
Services (Gold) and Manufacturing (Blue) Prices
January 2015 - Feburary 2023
(Source: Institute of Supply Management)
driven by debt. That can only go on for so long. More on that next week. We continue to expect economic softness in the months ahead. Meanwhile, an earnings recession is already upon us.
Countries
Russia’s equity markets were the best performing in the world last week. The country’s strong performance on the battlefield in Ukraine gave some hope that the conflict may end sometime in 2023. We continue to believe Russia is un-investable for many reasons.
Among countries we find investable, Mexico, Hong Kong, and Europe, generally, were the best performers. Mexico continues to be the beneficiary of a dissolving relationship between the United States and China. Hong Kong is the easiest play on China emerging from lockdown and Europe is just plain cheap.
Country Returns
On the new order front a similar story emerges. For services, new orders are particularly robust. No sign of consumer retrenchment here. Manufacturing, although still in contraction, is showing faint signs of rebound.
Services (Gold) and Manufacturing (Blue) New Orders
January 2015 - Feburary 2023
(Source: Institute of Supply Management)
February 27 - March 3, 2023
(Source: Bloomberg)
We believe the PMI data, in general, show an economy still some distance from recession. However, consumer spending on both products and services is being
Mexico is also the best performing market in the world, on a year-to-date dollar basis, higher by 21.4%. After that, Italy is 16.6% higher in dollar terms than last year. Mexico’s PE ratio sits at 11.0, a bargain. Italy is at 9.2. The point. Value markets, like value stocks, have been outperforming all year.
Crude oil was the best performing investment instrument. Most of the oil drivers are fundamental. Since their peak in November, the number of active oil rigs has begun to fall. China’s post-pandemic reopening seems to be pushing global demand higher as well. It’s hard to be negative on oil. Oil companies are more efficient than they have ever been. Both operationally as well as capital-wise. Despite their incredible run up over the past two years, they are also inexpensive, trading at only 6.9 times next year’s earnings and paying a 4.2% dividend yield.
Longer-term prospects for oil remain very attractive. Sure, one day we will all be driving battery operated cars. But most of us will be oil in the ground ourselves, long before then.
Instrument Returns
February 27 - March 3, 2023
(Source: Bloomberg)
Bonds gave the leader board to stocks on the back of broadly higher interest rates. Bitcoin was the worst performing instrument. Another crypto currency casualty, Silvergate, shut its payment network on suggestions the company itself is not viable.
We expect the crypto markets, generally, to continue suffering death by a thousand cuts. Certainly, there is a role for the underlying technology. But even that has as many weaknesses as strengths, all of which will need to be sorted and validated before being broadly accepted. Until then, crypto remains, in the words of
JP Morgan Chief Executive Officer Jaime Dimon, a pet rock.
Among equity instruments, there wasn’t a discernable trend last week.
Equity Instrument Returns
February
Sectors Among
equity sectors, the leaders were sectors that typically outperform during periods of economic strength. Underperforming sectors were the safe and reliable crowd.
Sector
Themes
Themes were all higher with no discerning characteristics driving each.
Theme Returns
February 27 - March 3, 2023
(Source: Bloomberg)
Conclusion
That’sit for this Weekender. Have a wonderful week. Next week we will address the labor market and consumer in significant detail.
Disclosure Statement
Index performance does not reflect the deduction of any fees and expenses, and if deducted, performance would be reduced. Indexes are unmanaged and investors cannot invest directly in an index. Past performance does not guarantee future results. Investing involves risk, including loss of principal.
The statements provided herein are based solely on the opinions of the author(s) and are being provided for general information purposes only. The information provided or any opinion expressed do not constitute an offer or a solicitation to buy or sell any securities or other financial instruments. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee it is accurate or complete. Consult your financial professional before making any investment decision.
The stock indexes mentioned are unmanaged groups of securities considered to be representative of the stock markets in general. You cannot invest directly in these indices.
