Oct 05 2023
October 5, 2023

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3rd Quarter Commentary 2023

The U.S. stock market fought an uphill battle during the 3rd quarter.  The Dow was down 2.2% for the quarter.  The S&P was down 3.1% and the Nasdaq was down 3.6%.  It was the end of the bear market rally which began last October when the so-called Magnificent 7 tech stocks scored outsized gains producing 90% of the overall market return for the year.  Three of the 7 came up limp and the other 4 were staggering as the quarter came to a close.  The market remains overvalued and oversold at the same time.

The Federal Reserve raised rates again in July by .25% and strongly suggested that it would do so again at either its November or December meeting.  Fed chairman Jerome Powell pressed the threat of higher interest rates for longer.  The latest inflation rate showed core inflation, which strips out food and energy prices, rose 0.1% in August.  The year over year rate dropped to 3.9%.  The Fed has set a target of 2%. The market is at present betting that the Fed will not raise interest rates again in this current cycle.

Rising interest rates negatively impact stocks which must compete with the promise of higher interest rates paid by risk-free government bonds.  The benchmark 10-year U.S. treasury is now at a 16-year high yield.  Tech and growth stocks face the greatest pressure from higher rates. 

There is debate over whether the Federal Reserve will engineer a soft landing, meaning no recession.  Or a hard landing/recession.  The Fed has never engineered a soft landing so bet accordingly.  The Fed makes decisions based on lagging indicators and seems to ignore future developments even when there is plenty of available evidence. 

The bond market continues to be in an inverted yield curve.  The 2-year treasury pays a higher interest rate than the 10-year treasury.  Every recession has been preceded by an inverted yield curve. 

The Fed wants unemployment to increase as a way to bring down inflation.  Current unemployment is a 3.8%.  The problem for the Fed is that unemployment is a lagging indicator of a recession.  Employers will hold on to employees until it is clear that margins have become too small to warrant the additional payroll.  The current push by employees/unions for higher wages is typical at this stage of the economy where inflation has hit paychecks.  There will be pay raises with layoffs to follow. 

GDP was revised down to 2.1% for the second quarter.  However, income has continued to drop.  The spread between the GDP and GDI is wider than at any time since the Great Depression.

Banks have continued to tighten lending standards to the point that very few loans are being approved.  The tighter lending environment has greatly impacted smaller businesses which are in the negative for the year to date.

The impact of rate increases usually becomes evident 12 to 18 months after the hiking began.  The cycle began in March of last year. 

Manufacturing has been in contraction but showed a slight tick up as orders came in for the Christmas shopping season.  Imports and exports are down, reflecting the downturn in economic activity. 

All U.S. trading partners are in recession or dipping quickly that way.  Germany has now officially been in recession for a full year.  Other European countries are following.  Japan and South Korea have recently gone into recession while China is moving toward an outright depression.  Trade between these countries has dropped significantly and worldwide manufacturing has gone into contraction.  As manufacturing slows so does the need for employees. 

The dollar continues to strengthen as other economies and currencies weaken.  The stronger dollar makes U.S. exports more expensive in other countries.  50% of the income generated by the S&P comes from exports.

The House of Representatives avoided a government shutdown at the end of October by agreeing to a continuing resolution that would be in place until mid-November.  The house is struggling with ways to reduce government spending.  The current U.S. government debt has passed $33 trillion.  Debt interest payment is now $2 billion a day.  Federal tax receipts have dropped making the debt situation even more difficult.

Rising yields on U.S. bonds are being caused by several factors.  The high U.S. debt is a concern but debt is a world wide problem.  The countries that usually buy U.S. treasuries are simply not able to do so.  China and Japan are both selling treasuries at a loss to generate dollars so they can trade in the dollar denominated marketplace.  The strength of the dollar also makes dollar denominated debt repayment more difficult for countries around the world.

The arrival of a declared recession is usually marked by recognition 9-months to a year after the event.  The Fed’s efforts to bring inflation down to 2 percent have been hampered by the massive cash handout by the government in 2020, 2021, and 2022.  Consumers were flush with cash and continued spending even as interest rates continued to rise.  That is coming to an end.  Saving accounts have been spent down and credit cards have been maxed out.  Credit card losses are already higher than going into the 2008 financial crises.  Bankruptcy is on the rise, both personal and business.  There has been a pickup in car loan delinquency and home foreclosure.  October marks the beginning of student loan debt repayments which have been vacationed since the outbreak of Covid.  Those payments are believed to be on average $400 a month pulling about $10 billion a month out of the economy.

A recession comes on slowly and then all of a sudden. 

Stock markets go up climbing a wall of worry and they slide down on a slope of hope.

I have spent the 3rd quarter rebalancing the portfolio in preparation for a move into recession.  We may see another positive move by equities as we get closer to Christmas, but the following rollover to the downside will take out those gains.  I have reduced our equity exposure and added long duration treasuries to the portfolio.  We will be punished for this position until we are rewarded.  The Fed has ended its last 6 rate hike cycles by drastically cutting interest rates.  Treasury prices have been beaten down so much that the recovery will present a huge opportunity.  While we wait for the Fed to reverse course we will be receiving monthly and quarterly interest payments. 

Thank you for your trust.