FDR has markets trapped in a narrow range — Week of May 1, 2023
S&P 500 Index
Dow Jones Industrial Average
Russell 2000 Small Cap
MSCI Europe, Australasia & Far East
MSCI Emerging Markets
Barclays U.S. Aggregate Bond Index
Merrill Lynch Intermediate Municipal
As of market close April 28, 2023. Returns in percent.
— Steve Orr
It seems like we were just on spring break and looking to the end of the first quarter. But no, April has come and gone. Typical pre-election Aprils see stock rallies of 3% or more. Not this time. The Fed, Debt and Recession (FDR) has thrown a wet blanket over recent performance, keeping stocks largely in a narrow range. April’s 1.5% gain for the S&P 500 was courtesy of a handful of mega-caps that dragged the index higher. Five stocks accounted for 42 of the index’s 60-point rise: Microsoft, Apple, Facebook, Lilly and Exxon. Another 253 names contributed a point or less, and 223 contributed a negative 68 points to the index’s return. The bottom leader? Tesla fell 21% in April after discounting cars amid falling sales, dropping the S&P 500 14 points.
Mid-cap, small and emerging markets all fell in April, led by China’s 5% drop. China’s reopening story is behind schedule, as is the cleanup of its real estate woes. Small and mid-cap results continue to be hampered by bank worries. Over the weekend the FDIC sought out more bids for pieces of First Republic and JP Morgan won the deposits and loan book.
Bonds fared slightly better across the board. The Barclays U.S. Aggregate index finished April with a 0.6% gain, thanks to slightly lower interest rates 10 years and out. Maturities in the six-to-twenty-four-month range rose more than a quarter of a point thanks to strong statements from FOMC members and renewed Debt worries.
Let’s pull out the easy bricks from the market’s Wall of Worry first. This Wednesday the FOMC will again raise short-term rates by a quarter of a percent. The new target range for Fed Funds will be between 5% and 5.25%. The looming question for Wednesday afternoon is how hawkish will the tone be of the press release and Powell’s press conference? We expect Powell to remain hawkish and talk about rates staying at these levels or higher depending on the economic data.
The Fed’s favorite inflation gauge, core personal consumption expenditures, is still elevated at 4.6%. It peaked a year ago but is not coming down as fast as the Fed would like. The consumer price index finally broke through 5% last month. We expect it will sit at this 4.9% level over the next several months. Declining housing and rent prices will reduce readings but be offset by rising fuel and auto prices. We still believe a flat 4% by the end of this year would be a welcome development, allowing the Fed to begin rate cuts in the late fall after a six-month pause.
Higher rates are starting to have an effect on the economy. Historically, most business cycles turned lower due to lower availability of credit. Combine less credit with higher interest rates and the economy eventually slows into a recession. An area of concern we are watching is used car financing. Most car dealers do not pay “full price” for cars. Rather, they pledge them as collateral for a bank loan and as each car is sold, use a portion of the sales proceeds to pay down the loan. This is called “floor plan financing” in the trade. Rather unnoticed last month, Wells Fargo, Ally and Capital One exited the floor plan business. Citizens Bank notified dealers in New York last month that it too was scaling back on its car dealer business. Another bale of hay for the MARE.
Markets got a brief lift last week from Speaker McCarthy’s debt bill win in the House. As we mentioned last week, the bill combines a one-year moratorium on the debt ceiling, while implementing a number of spending cuts. Stocks have rarely fared well in the weeks leading up to the government running out of money. The back and forth during Congressional negotiations pushes daily volatility higher, unnerving most investors. Congress has operated with a debt ceiling limit since World War I. Under the Constitution, only Congress can authorize spending and the borrowing of money to pay for spending. The debt ceiling is unique to the U.S. It only specifies how much the Treasury can borrow and does not limit deficit borrowing.
Until 1917, Congress authorized each debt the federal government issued. To finance its involvement in World War I, Congress established an upper limit on borrowing. This allowed the Treasury flexibility on when and how much to borrow. Depending on how you look at it, Congress has raised the debt ceiling at least 90 times since 1917. Seventy-four of the raises were between 1962 and 2011. No surprise, the debt ceiling has never been reduced.
The Treasury hit the current maximum debt ceiling of $31.4 trillion on January 19. Since then, Secretary Yellen has been delaying pension contributions and paying bills as quickly as possible. These “extraordinary measures” were aided somewhat by annual tax payments last month. Most experts think the Treasury runs out of money in the July timeframe. If the Treasury does run out of money, then parts of the government may shut down. This has occurred nine times since 1980.
The media talks about the Treasury defaulting on payment of its debt in the same breath as the debt ceiling. This is largely a scare tactic. The Treasury defaulted once, failing to make a payment on Treasury Bills in 1979. That was due to a computer error that was quickly fixed. In prior debt ceiling cases, the Treasury has accelerated borrowing after the debt limit raised. The increase in the supply of Bills lowers their price (higher yield). That phenomenon is evident today in the August maturities. Those Bills yield just above 5%, while their September cousins yield only 4.85%. Traders are betting the date the Treasury runs out of our tax dollars will be in July. The Treasury will then need a slug of borrowing to raise money to pay bills in August.
Consider the debt limit debate similar to a teenager with a trust fund he controls. He wants more allowance, pitches a fit and argues with himself over how much to increase his allowance. Then at the last minute (mid to late June 2023) he raises his allowance. Speaker McCarthy sending a spending and ceiling bill to the Senate is a first step in starting negotiations. Usually, a bill does not come together this far in advance. Our sources in D.C. suggest a better than 50/50 chance a bill is signed before July. That signing would be a good outcome that would calm markets.
Earnings season is half over. To date, 53% of the S&P 500 has reported, and results are a bit better than anticipated. The number of companies beating analysts’ estimates is running above its 10-year average, according to FactSet. Last week, earnings were on track to fall -6.3% over last year’s first quarter. After last week’s reports, the blended average drop is only -4%. If the decline in earnings sticks through the rest of the reports, then it will be the second straight quarterly earnings drop for the index.
Positive surprises from energy, industrial and tech sectors led the better results. Given the number of revenue and earnings beats, analysts are sticking with their projections of positive earnings growth later this year. Mark us down in the doubtful column. A majority of the management comments from companies were downbeat or uncertain about the outlook for the rest of the year.
Other than state tax receipts, we do not have any forward-looking economic indicator in even the neutral column. All sit in the red zone. Does that mean a recession is inevitable? No, but the odds for missing one are small. We have been impressed with the steady plodding of the U.S. economy over the last year. Resilience over Recession would be a good label.
The Fed should deliver its tenth rate increase on Wednesday. The ripple effects, such as car dealer financing, are not done. We do think the worst of the increases is over. That CPI might reach or fall below the Fed Funds rate in the fall is encouraging and should help market psychology.
Valuations remain elevated, trend is trend-less, and sentiment is mildly negative. May and Congressional negotiations are upon us. A time to be cautious indeed.
Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here.
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