A Message From The Team: The Market and Risk
The past quarter began with a couple of bank failures and then ended with a failed coup in Russia. In between, we witnessed a high stakes negotiation over the debt ceiling, an interest rate increase and more talk of a recession. With that backdrop you would have expected large swings in the stock market and not very good economic news.
Instead, stock market volatility, as measured by the VIX index, has been muted to low levels we haven’t seen since before the Covid pandemic, and economic indicators have come in better than expected.
Why Are Markets Smiling?
Over the past year, we’ve seen the Fed raise short term interest rates from 0% to over 5.0% in an effort to bring down inflation, which peaked at over 9.0% in June 2022. While the Fed continues to talk about higher rates for longer, we are much closer to the end of rate increases than the beginning. Real progress has been made on inflation, the debt ceiling issue was resolved without a U.S. government default and the bank failures have been limited. Improvement in these factors has allowed markets to “climb a wall of worry.” So far this year the S&P 500 is up over 15% and the NASDAQ is up over 30%.
While we continue to expect a recession in the next year, the timing and severity of a recession may be later and less severe than previously thought. If a recession does occur, it will be solely because of the Fed intentionally raising rates and reducing the money supply to rein in inflation. We believe that the Fed’s pause in raising rates in June will provide time for inflation data to catch up with anecdotal evidence that inflation is cooling. We are observing disinflation (slower growth in prices) as well as deflation (lower prices) in housing, goods transportation, energy and other segments of the economy.
While the Fed has indicated they expect to raise rates two more times by year end, that may not be necessary given enough time for the inflation data to reflect the above trends. If a recession does occur, the economy is in a good position to weather a downturn and rebound quickly. The job market continues to run hot with nearly 10 million jobs currently open, compared to the record prior to the pandemic of 7 million open jobs. Household and company balance sheets are in good shape with low debt service requirements. And finally, there doesn’t seem to be any excesses in inventory, housing or autos, which we typically see prior to a recession.
Having discussed the good economic and market news, we don’t want to ignore real risks ahead. First, the price-earnings ratio for stocks is elevated compared to the beginning of the year. The PE for the S&P is now 19.1 times the next 12 months estimated earnings. If there is a recession that is steeper and longer than expected, we could see company earnings decline at the same time that the market gets more conservative and lowers the PE ratio.
Second, the performance of the market has been primarily driven by the top five stocks in the S&P 500. The good performance won’t be sustainable unless positive momentum broadens out beyond these five companies.
Third, unexpected geopolitical events could disrupt the world economy. While the failed Russian coup was a surprise to most of us, the impact on the world economy was benign. The next geopolitical upheaval could have greater economic and financial consequences. Fourth, there is growing concern that high office vacancies could lead to loan defaults, bank failures, and decline in urban areas. Along those lines, a fifth risk is that banks get more conservative, reduce available credit and cause an economic slowdown. We think that these last two risks will play out over a long period of time, but we are watching all of these areas closely.