| 2nd Qtr.
| 12 Mo.
|10-yr Treas. yield||3.82%||3.49%||+0.33%||2.97%||+0.85%||-0.06%|
|Fed funds rate||5.0-5.25%||4.75-5.0%||+0.25%||1.5-1.75%||+3.50%||+0.75%|
(stock indices are before dividends; yield and rate changes are absolute changes)
The quarter can be summed up in two themes – technology (especially the mania around “artificial intelligence”, or AI) returned to lead the stock market rally, and economic data has stalled any anticipated recession. Both the S&P 500 and the NASDAQ hit “bull market” levels, more than 20% higher than their 2022 lows. The rise in interest rates slowed considerably, at least temporarily, but safe havens still attracted investor interest, with gold hitting new highs before backing off a bit. The US dollar mostly treaded water as did international stocks, although their one-year performance has been strong.
The Fed remained the focus of the markets, raising rates in May and pausing its rate increases in June for the first time in 10 meetings. However, the Fed indicated the pause would likely be temporary and two more hikes are possible, with the target rate reaching as high as 5.6% before falling a full percent in 2024. The inverted yield curve (two-year Treasury yields being higher than 10-year yields) hit its steepest point since 1981. An inverted yield curve has preceded a recession by six to 24 months since 1955, but the yield curve has already been inverted for nearly a year with no recession yet. The Fed was not alone, as the European Central Bank raised rates for the eighth consecutive time and the Bank of England raising their rates even higher than the Fed; China was alone among major economies in cutting interest rates to promote growth.
The May jobs report showed an addition of 339,000 jobs, exceeding expectations for the 14th consecutive month, and unemployment stayed low at 3.7%. Both first-time unemployment claims and continuing claims remained low as well, reflecting the strong job market. Employees are working fewer hours as employers are delaying layoffs and retaining current employees. This has caused worker productivity to fall for five quarters, which is typically contrary to GDP growth. Core inflation for May came in at 4.6%, the fifth month at either 4.6% or 4.7%, with rents almost 9% higher than the prior year. Construction spending on US factories has nearly doubled from its 12-year average, although other measures show manufacturing in a slight contraction for seven months. Low inventories of existing homes for sale led to a 20% drop in sales but boosted new home sales to a 20% jump; median prices of both categories were down 3% to 8%.
In typical fashion, Congress averted the debt ceiling crisis at the last minute, with some spending limits and agreement on veterans’ care, tightened requirements for some assistance programs and retention of clean energy tax credits. The Supreme Court struck down President Biden’s plan to cancel student loan debt, and the SEC broadened its assault on cryptocurrency by suing Binance, another large crypto exchange. Ukraine began its expected counteroffensive, while Russia endured a one-day uprising by the Wagner mercenary group which threw Putin’s leadership into question.
The final revision of first quarter GDP growth was increased to 2% from the prior 1.3%, driven by consumer spending at the time and stronger exports. The World Bank raised its 2023 global growth estimates due to US resiliency and the broader reopening of China’s economy. US consumer confidence hit an 18-month high, particularly for present conditions, although six-month expectations remained below recession levels. Consumer spending slowed from its strong first quarter levels, but incomes rose steadily; consumers still have an estimated $500 billion in excess savings from pre-pandemic trends.
Before and in the early stages of the pandemic, modern monetary theory (MMT) was getting a lot of attention and some acceptance. MMT holds that if a government controls its own currency and needs money, it should just print money, as long as the economy can deliver the needed goods and services. MMT minimizes any concerns about paying government debt and bases government spending on available resources and political priorities. In short, deficits don’t matter much.
Previous large debt loads in developed nations, particularly Japan, had not devastated those economies as badly as traditional economists had expected, and the 2008 recession left lasting scars on the US economy and society. MMT began to gain acceptance in policy and political circles (sometimes not explicitly, as politicians were cautious to say outright that deficits don’t matter, but certainly in principle).
MMT gained its popularity in a period of low inflation and low interest rates. After pandemic and other spending, the federal debt is at $30 trillion, and fortunately the government has not had any trouble selling bonds to fund the deficit spending. Since the pandemic spending was a crisis, not unlike necessary military spending during a war, it did not undergo the thorough impact assessment on inflation that proponents of MMTR would have preferred. Still, the economy recovered rapidly, and the market has not punished government debt.
Now, economists are identifying government spending as one of the causes of our current inflation, and MMT is swept up in the blame. MMT advocates argue that there are methods other than monetary policy driven by the Fed that can help soften inflation, but these are mostly spending priorities that are unlikely to ever reach consensus in Congress.
The debt ceiling debate has revived calls for “fiscal responsibility” or working to stabilize and even reduce the deficit over time. Of course, those calls have not resulted in anything resembling fiscal responsibility for a long time, with both parties spending with little regard for revenues. And while the US does have a sound currency and plenty of buyers for its debt, both of those strengths are under attack. In fact, countries like China would like nothing better than to see erosion in the supremacy of the US dollar.
It should become clearer in the foreseeable future whether there is any real commitment to, if not balancing the federal budget, at least paying attention to both spending and revenues.
Financial markets are made up of all types of participants, there is never full consensus and there are always conflicting strategies being employed; that’s what makes markets so interesting and unpredictable. Towards the end of this quarter there were two indicators which at first seem contrary but are just reflective of different perspectives and goals.
The first notable market factor is the amount of “short interest”, which hit $1 trillion and was the highest since April 2022. This amount equaled 5% of all shares in the US stock market. When investors (hedge funds and institutional investors) “go short”, they sell borrowed shares in hopes of the price going down, at which point they can buy the shares at a lower price, replace the borrowed shares and profit by the price difference between the sold borrowed shares and the shares they purchased to replace them. While some of this short interest may be to protect a bullish investor from the possibility of a market decline, for the most part short interest is a straight bet that the market or specific stocks will fall.
But this quarter’s market rally has inflicted heavy losses on these short sellers, at least on paper. If all the short sellers had to buy shares to replace the borrowed shares they had sold, those purchases would be at higher, not lower, prices, and as of June 21 they would have suffered $120 billion in losses. In addition to those potential losses, when a market goes against short bets, something called a “short squeeze” can occur. This is when the short seller decides to cut their losses and buy the required shares, and this buying pushes prices higher, forcing more short sellers to buy, and so on.
The second market factor is the “fear gauge”, also known as the volatility index. This index measures the market’s expectations for the strength of near-term price changes of the S&P 500 index, and it generally rises when stocks fall (fear goes up) and declines when stocks rise (less fear). Aside from its connection to market moves, it also measures those expectations, so if investors are not convinced that a market rally is sustainable, the index will go up. This index hit a 2 ½ year low in June, indicating that investors are complacent and are taking less action to protect themselves from a market drop. (A contrarian would say when the majority is complacent, it’s time to be scared.)
So, which is it – the short sellers are right that the market will fall, or the volatility index showing comfort in the current and presumed continuing market rally? To be frank, we really don’t care. Both indicators, while interesting, are relatively short-term and can change abruptly. And the investors whose actions drive these indicators have a very high-risk, high return approach. They are not concerned about the long-term but are looking only at their current assessment and results.
We think much more simply – if we want to be in a market for the long run, we are in it. If we don’t want to be in a market, we aren’t. All the technical tools and fancy strategies just make it more complicated.
You Ain’t Seen Nothin’
Getting inflation under control has been the focus of the Fed since early 2022. With the most rapid increase in short-term interest rates ever, the target Fed rate is now 5.25% (check) and consumer inflation, after topping 9% last year, is still hanging around near 5%.
Both the increase in rates and inflation have caused challenges for consumers, banks and the economy, but many of us remember 1980, with inflation over 14%, and 1981, with short-term interest rates over 18% so the Fed was aggressively tackling inflation. (I have often recalled that my first mortgage in 1983 was at 12 3/8%, and I was happy to get it.)
Still, inflation and interest rates have been far worse in other countries. Argentina, which has defaulted several times, recently raised their benchmark interest rate to 81% with forecasts of 110% to 130% by year-end. Inflation was running at 7.7% this spring, contributing to a 40% poverty level.
“Hyperinflation”, while rare, occurs when prices of goods and services rise more than 50% PER MONTH. Hyperinflation is typically caused by governments printing too much money and high demand for goods and services. Once inflation begins to rise, the increased money supply increases demand because buyers want to buy before prices go up even further, the money supply increases more, demand increases more, and off it goes. Buyers will often stockpile goods, creating shortages which makes inflation even worse.
The Weimar Republic in Germany following World War I is probably the best example of hyperinflation. Saddled with billions in war reparations, the government left the gold standard (the ability to convert the currency to gold) and issued 92 quintillion marks, crushing the value of marks. Production collapsed and prices doubled every four days. Eventually, a new currency was introduced, debts were revalued, and production resumed, but Germans endured plenty of pain which created the opportunity for someone like Hitler to promise salvation.
Brazil, Peru and Bolivia all suffered bouts of hyperinflation in the 1980’s and 1990’s, as did Yugoslavia during the period it was breaking up into its five successor nations. Zimbabwe famously printed a Z$100 billion banknote before introducing a new currency and redenominating the currency several times in the late 2000’s. Those banknotes are now collectors’ items with far greater value than their purchasing power.
“Galloping” inflation is not as catastrophic as hyperinflation but still poses significant challenges. Galloping is typically described as a rapid increase in inflation to a 10% or greater annual rate. Its causes include a rapidly growing money supply, high and sustained military spending, low prices for major export goods or commodities, and high external debt in a stagnating economy. Galloping inflation can have an outsized effect on middle- and low-income people, since they have less financial reserves to get them through the spike in prices. The US did have galloping inflation in the post-World War II years, which was resolved as production shifted to the peacetime economy, and in the 1970’s, precipitated by the OPEC oil embargo and eventually softened by new energy sources and efficiencies.
We find ourselves in a period of “walking” inflation, which accelerates as excess money is spent, demand is high, wages begin to go up to keep up with prices and the cycle continues. The stubborn inflation of 1980 was also the result of walking inflation. The main risk is that the cure for walking inflation (the higher interest rates the Fed has been implementing) can apply the brakes too much and lead to a recession. But doing nothing can price many consumers out of basic goods and services, not to mention the increase in the price of assets that are in short supply. A major contributor to our current inflation is the low supply of new housing, which has been underbuilt since the 2008 recession.
Compared to other nations’ inflation episodes, our current walking inflation is pretty tame. Short of some major external economic shock, or a change in the US dollar’s status role as the international reserve currency, or an ever-increasing budget deficit, or some combination of these changes, it is extremely unlikely that the US could have hyperinflation. But these things can come out of nowhere, so it remains important that we protect our strong financial standing.