Jul 05 2023
July 5, 2023

2023 – 2nd Quarter Commentary

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The US stock market continued its bullish trend through the 2nd quarter.  Primarily on the backs of seven tech stocks which heavily outperformed the broader market.  Without the returns of those seven stocks the S&P performance for the year would be near zero.  The Federal Reserve’s efforts to fight inflation by raising interest rates took a breather in June.  The Fed announced it was taking a “break” from interest rate hikes but that the hikes would resume at the July meeting, with anticipated hikes of half a percent to a full percent before the end of the year.  In his comments, Fed chairman Powell stated the goal of a 2% inflation rate remained in place.  Powell had no clear explanation for why the Fed was pausing after raising rates at every meeting since March of 2022.  Chairman Powell continued to point to the strong US labor market as the problem and its potential to push up inflation.  Inflation has been slowly coming down in the US and the word “deflation” was even used by Powell in his remarks. 

Employment, especially blue-collar jobs, remained steady in the US.  Most layoffs have been white collar employees in the tech industry.  There are approximately ten million jobs that need to be filled.  The wave of retirements by the boomer generation, the smaller numbers in the younger generations, and the need to hire workers to fill jobs moving back into the US from China have kept employment strong.  The Fed believes forcing more workers, many more workers, into the unemployment line would do the trick at bringing down inflation. 

Employers for the moment are not going along with the Fed’s plan.  Finding employees after Covid was like hunting for hens’ teeth.  Employers are hoarding employees in hopes that the economy will turn, flowers will bloom, and every employee will be needed.  The last shoe to drop going into a recession is employee layoffs when business owners realize the Fed has pushed the economy too far in the wrong direction.  Recessions happen slowly and then all at once. 

The 2nd quarter was fun, but the 3rd quarter has much more potential.  There is a banking crisis looming despite the news that 23 of the largest US banks passed a stress test.  Banks were directed by the Fed to buy US treasuries when rates were zero.  Those rates have gone up 4 to 5 percentage points and the values of the treasuries have gone down.  Banks are now holding near $600 billion dollars in lost treasury value.  Depositors have been pulling funds from banks to place in money market funds.  The interest is paid to those funds by the Fed on revenue it generates from loaning money to banks so the banks can cover demand withdrawals.  Banks borrow on short-term rates and lend on long term rates.  There has been an inverted yield curve for the past year with short term rates higher than long term rates.  So, banks have stopped lending money.  Around $3 trillion dollars in commercial real estate loans are scheduled for renewal during the 3rd quarter.  Those loans for commercial office and retail space were made when rates were around 3 percent.  The loan renewal rates are now above 6 percent.  Expect loan defaults and bankruptcies.  Treasury secretary Yellen has stated that new bank mergers should be expected as the commercial loan hairball is combed out. 

Consumers reduced their spending and increased savings during the 2nd quarter.  Wages went up but not enough to keep up with the stated rate of inflation recognized by the Fed.  In October, holders of student loan debt will be required to begin making monthly payments.  That would be an average $400 payment for a total of $10 billion dollars monthly taken out of the economy.

1st quarter GDP took some surprising turns during the 2nd quarter moving from the first announced reading of 1.1% to a final reading or 2%.  The GDP number reflected an increase in used car sales after prices dropped, consumer purchases of reduced priced goods after the Christmas holidays and a drop in imports alongside higher exports.

There is a global manufacturing recession and a slowdown in the service sector.  Two of the world’s largest exporters of manufactured goods are in recession.  Germany, the economic engine for the European Union, is officially in recession.  Inflation across Europe remains higher and stickier than in the US.  Europe is facing a declining consumer base, self-inflicted energy shortages, and food production issues.  Germany also tied itself closely to the Chinese market.

We do not want to have what Xi’s having.  Inflation is not the problem in China.  The CCP recently announced small interest rate cuts that were more for show than a real solution to the country’s problems.  Chinas has for the past 20 years played the role of pulling the world out of economic slowdowns, positioned as the world’s factory floor.  Industry is now moving out of China as fast as possible.  India, Vietnam, Mexico and the US are now the new homes for factories once located in China.  Unofficial estimates show unemployment among Chinese youth at over 20%, unemployment across China at 25% and urban unemployment at near 50%.  Provincial governments in China are heavily indebted and some bankrupt.  Why this is important was the earlier promised “China reopening” that would reignite the global economy.  The reopening was not even a fizzle but more a display of what deflation does to an economy.  China faces a long road to recovery and will be exporting deflation to the globe as it struggles to regain its footing.  Think Temu.

 The Fed promised more rate hikes beginning with the late July meeting.  I’m currently leaning toward a belief the rate hikes are done, and the Fed must now deal with the damage it has already inflicted.  The Fed is fully aware of the fragility of the US banking system.  Rate hikes would spell bank failures.  With more and different letters. 

As we move through July, I will be decreasing exposure to equities and commodities.  I believe we are moving into a period of deflation, job losses and interest rate cuts.  The bond market is screaming recession and the Fed’s pause could indicate the Fed is seeing the same cracks forming in the economy.  I will continue to add to our long treasury position, the TLT.  As interest rates go down, the value of the TLT shares will go up, and we collect an interest payment while we wait.  Gold and commodities do not fare well in a recession.  Dividend payments remain an important consideration.

There are other potential problems that bear watching.  We recently saw a low-grade coup attempt in Russia.  The coup showed problems between the different Russian military groups fighting in Ukraine.  There are concerns that the Russians or the Ukrainians will damage a nuclear power plant, blame the other side, and create a potential nuclear disaster in Europe.  The CCP may decide to redirect the attention of the Chinese citizens by attacking Taiwan.  It is more likely the attack would come after the January presidential elections in Taiwan.

I continue to keep a positive attitude and the belief that something will happen.  It is always good to see you.  If you would like to set up a meeting in person or by phone, please give me a call on my cell 865-368-1917.  I look forward to hearing from you.