While we’ve been expecting an uptick in volatility in the back half of the year, we didn’t expect the spark to be a lowering of the U.S. credit rating as occurred earlier this month, when Fitch Ratings lowered it from AAA to AA+.
The move is both in part ridiculous, given America’s overall economic vitality, and in part justified, given a current annual deficit of $1.5 trillion.
In response, yields across the spectrum moved up with the 10-year treasury solidly above 4%—at 4.17% as of this writing. Such moves are likely to further slow an already slowing economy.
Brian Lockart, of Peak Capital Management, centers his call for an impending recession on hard data and history.
“The Conference Board’s Leading Economic Index suggests a hard landing (recession) is far more likely,” Lockart notes. “Since 1960, there has not been a time where the LEI contracted by today’s level without a recession following soon after. Fortunately, the construction of the Index is transparent in terms of what is being measured. Items such as average work week, Institute for Supply Management data, consumer expectations, building permits, nondurable capital goods orders, jobless claims, and stock market prices are among the 10 data points that comprise the index. As of late July, the only data point that is positive is stock prices, all others contribute to the negative reading. If stock prices were neutral, the LEI would have a decline of nearly 10% instead of the current 7.5% decline.”
The move in the yield curve and slowing data may lead the Fed to cease its rate-hike campaign, but recent leading inflationary data doesn’t appear to be one thing that will.
As noted by Brian Wesbury, of First Trust, the data isn’t as rosy when one reads beyond the headline numbers.
“Core inflation, which excludes food and energy, is up 4.1% on a year ago-comparison from the 5.4% peak last February. In other words, core inflation is taking a much slower slog lower,” Wesbury states. “Note that the Fed is now closely watching a subset of inflation dubbed the ‘supercore,’ which is services only (no goods), excluding food, energy, and housing. That measure also rose 0.2% in June and is up 4.1% versus a year ago (down less than 1 percentage point from the 4.9% peak in November 2021). Inflation continues to take a toll on the economy, which is also feeling more of the effects of the decline in the money supply over the past year. The Fed’s fight is not over, and there is plenty of room to stumble before crossing the finish line.”
One of the reasons we remain cautious about risk markets in general, especially at recent levels, is the reality of already slowing data coupled with the reality that nearly all of the Fed’s historic rate-hiking campaign—both in degree and speed—has yet to be felt by the economy.
Torsten Slok spoke to this in a recent piece titled, “The Monetary Policy Transmission Mechanism Takes 12 to 18 Months.”
In the piece, Slok says, “The Fed has raised the Fed funds rate to 5%, and the lagged effects of Fed hikes will continue to drag down growth over the coming 12 months. … In other words, the transmission mechanism of monetary policy takes time, and the drag on growth from lagged Fed hikes over the coming year will be significant. That is why a recession is a more likely outcome than a soft landing, no matter what happens to inflation.”
Yet stocks have surprised to the upside, yields have remained rangebound despite calls for larger moves, and the Fed has shocked many by raising rates multiple times this year and remains resolved to tame inflation despite the market’s plea for an end to their campaign.
What does all this mean?
As we all learn over and over again as investors, predictions and prognostications are fruitless and not a path to repeatable success, however, process and probability weighting can be.
Headlines today cheer current realities and make pronouncements of an impending soft-landing. We don’t dispute that outright, but our process, which digs far deeper into the data, shows that the probabilities of a hard landing are just as strong, if not stronger. The result is a belief in being as diversified in our allocations as we’ve been in a very long time.
Too many feel compelled to make a call, especially on things such as stocks or real estate these days, without taking the time to recall all the times they’ve been humbled, and without having any true working knowledge of useless, if not outright ridiculous sounding, calls on a general asset class.
It is key to understand your true underlying exposures, how those may be impacted by various market conditions, and how those exposures work together with your other positions to protect you.
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