Market Commentary - August

Monthly Update

After 5 months in a row of gains and in 6 of the past 7, the S&P 500 took a breather in August with a 1.8% drop[1]. This was joined and mostly driven by a correction in big cap tech stocks as the NASDAQ was down by 2.2%[2]. More pronounced though was the 5.2% fall in the small cap Russell 2000[3]. The selloff was global as the Euro STOXX 600 declined by 2.8%, the Nikkei 225 was lower by 1.7% and the Shanghai composite weakened by 5.2%[4].

The markets were digesting Q2 earnings reports that saw a year-over-year drop of about 5%[5]. While that was not as bad as the initial forecasts of about an 8% decline, it does follow the prior two quarters in which we saw earnings fall. Also, many big cap tech stocks rallied into their earnings releases, only to have a ‘sell on the news’ event after the reports. Year to date, most global markets are still up nicely after the tough 2022 but markets have been very bifurcated.

Noteworthy too in influencing markets has been the continued rise in long-term interest rates that seems to be both global and happening for a variety of reasons. The US 10 yr. yield ended the month at 4.11% and as of this writing in early September has risen to 4.26%[6]. It got as high as 4.34% in August and that was a level last seen in 2007[7]. This follows a further rise in the 10 yr. JGB yield in Japan to .65%, a 9 yr. high[8]. The 10 yr. gilt yield in the UK ended August at 4.36%, but intra month it touched 4.75%, a 15 yr. high[9].

The flow through to the broader US economy has been immediately seen in mortgage rates which now stand at a 23 yr. high at around 7.5%, according to Bankrate. The housing market in the US is really upside down right now because of the sharp rise in rates as existing home sales, where 82% of mortgage holders have a mortgage rate under 5% and 62% have one less than 4%, according to Redfin. These homeowners are reluctant to give this up, thus resulting in less existing home inventory that is now being filled by the home builders. So, the number of existing home transactions are near the lowest level since 1995, according to the Mortgage Bankers Association, but the pace of new home sales is doing better, helped by builders subsidizing lower mortgage rates for buyers.

After jumping by 15% in July, WTI crude oil rallied another 2.8% in August and as of this writing stands at around $87 per barrel[10]. OPEC is remaining diligent with its supply cuts at the same time the rig count in the US continues to fall and global demand remains pretty good. If this continues, it has the potential of complicating the Fed’s fight, along with other central banks, against inflation.

With regards to inflation, it continues to slow down on a rate of change basis when looking at the core rate which excludes food and energy. The July CPI seen in mid-August saw the core rate of inflation moderate to 4.6% y/o/y, the lowest since October 2021, though still more than twice the Fed’s target rate[11]. I do expect the inflation trend to further decelerate as the rental growth slowdown gets captured in the government statistics. We also saw the August jobs number on September 1^st, and it reflected further moderation in the pace of job gains which could also help to cool inflation. The 3-month average in monthly payrolls is now at 150k vs the 6-month average of 194k and the 12-month average of 257k[12].

Moderating inflation and the labor market cooling is likely enough for the Fed to pause its rate hikes at their September meeting, as the market anticipates. Rate hike odds for one more hike after that meeting is at 44%, according to the fed funds futures. If the case that the Fed is most likely done raising short term rates, which I think they are, the question then is how long they keep rates where they are. ‘Higher for longer’ has been a consistent theme of mine, and now the markets, at the same time the Fed keeps on with quantitative tightening (“QT”) so tight monetary policy will remain with us for a while as the Fed doesn’t want to give up on their inflation battle. There is one thing to see a drop in inflation and another thing to keep it down. I still expect a more sustainable rate of inflation in the coming years of 3-4% rather than the 1-2% that we lived through before Covid after the Great Financial Crisis.

Expanding on the comments about interest rates, particularly longer maturity Treasuries, the rise could be due to a few different factors that I speculate on. 1)The Bank of Japan has finally joined the monetary tightening party and they were the last major holdout until now and whose higher rates could lift global rates, 2)The US is issuing a huge amount of Treasury supply, both post debt ceiling fight but also to plug the ever rising budget deficit which stands at about 8% of GDP in the 12 months thru July, 3)This at the same time the Fed is essentially selling Treasuries via QT, and foreign central banks and US domestic banks sharply pull back from the market after previously being a major player, 4)Oil prices are at one year highs, and 5) The US economy continues to hang in there[13].

Following up on the US economy after talking about the housing market, other parts of the economy are showing mixed signals too. The lower to middle income consumer seems to be prioritizing their spend on non-discretionary spending and less on discretionary, according to what we heard from a slew of retailers over the past month in their earnings reports and calls, which was the case in the prior quarter as well. The cumulative impact of higher inflation and now higher gasoline prices is stretching people’s wallets. The higher income consumer is mostly spending on leisure, hospitality, and travel and less so on the goods that they focused on during Covid.

US manufacturing, and the manufacturing sector around the world, is feeling this shift in spend to services from goods as it’s been in a contraction for 10 straight months as seen with the Institute of Supply Management manufacturing report. Hopefully soon we’ll see some inventory restocking after the aggressive destocking we’ve being seeing instead. Capital spending has been mixed as big companies have the wherewithal to continue to invest in their business but many others, particularly small and medium sized companies, are prioritizing spending themselves.

The area of the US economy that is getting a big lift is the renewable energy space, particularly anything related to electric vehicles and battery production. Spurred on by federal government tax incentives, loans and grants, companies around the world are spending billions on factory production to produce for this sector. Also, the CHIPS and Science Act is encouraging the domestic development of a bigger US semiconductor manufacturing presence. Lastly, there is a lot of money now being spent at the state and local level on infrastructure. While the goals are laudable, we’ll have to see about the means in terms of how efficient the spending will be and what capital will inevitably be misallocated to some extent. Either way, this will lift US activity in these sectors but could also help to lift inflation again, not making the Fed’s job any easier.

For both good and bad, China has been an important story this year. The good was the reopening of its economy after they rid themselves of the fight against Covid that they were never going to win via lockdowns. The difficulty now is their manufacturing sector is challenged just as the rest of us are too. Also, residential real estate developers are under major financial stress as the pace of home sales has slowed dramatically as many were dramatically overleveraged. The bright spot of the Chinese economy has been consumer spending on travel, leisure and hospitality as people get back to some normality post Covid.

Conclusion

I’m going to repeat how I concluded the July monthly letter as it still applies by saying it is not easy to balance all of these moving parts and come to some coherent summary since there is so much going on and sometimes themes conflict and don’t make sense. That is the investment business, however, and the life we here at Bleakley have chosen. While the US economy is not in a recession, one ahead is still very possible. We have the positive of falling inflation but one that I believe settles out at 3-4% rather than 1-2%. We have the Fed just about done raising short term interest rates but they could stay high for a while, long term interest rates are now rising again and quantitative tightening continues on. We have had a robust rally this year so far, but valuations are now again in elevated territory.

Whatever comes our way though in this very tricky investing landscape, it remains vital that investors have adequate short liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor.

Disclaimer

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[1] Bloomberg

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