Q2 - June 2024
As we are now one year out since the Fed last raised interest rates, everyone is looking around for signs that the efforts to rein in inflation are working. Milton Friedman’s famous explanation of monetary policy’s “long and variable lags” has most of us today asking “how long and how variable?” given the resiliency of the market and an economy that keeps trudging along despite the Fed forcefully hitting the brakes. The effects of the higher interest rates become clearer when you look at the real estate market. Commercial real estate continues to be an area of concern, as banks juggle refinancings for retail and office buildings which struggle with depressed occupancies levels, and delinquencies rates on construction loan are on the rise¹. The National Association of Realtors Pending Home Sales Index sits at its lowest levels in its twenty plus year existence, and the May reading of the Architecture Billings Index fell to a level only reached during past recessions. If you need a real world pulse on the market, look at the cost of 2x4 lumber, which dropped to its lowest price since the early days of the covid shut down². Jobs have been plentiful, which has been the saving grace against the stubborn inflation, but certain jobs that provide a good pulse on the economy such as trucking, are clearly in decline. The consumer looks stretched, with muted retail sales this year, confirming the most recent University of Michigan’s Consumers Current Conditions Index hitting a one year low.
The headline equity indices have been rallying since October of 2023, coinciding with the change in tone at the Federal Reserve after raising rate more than five percentage points in less than a year and a half. Since mid-October, the 2 year US Treasury yield, which peaked around 5.2% has declined half of a one percent. This “rate relief” has helped the S&P 500 Index rally more than 26% and the small cap Russell 2000 Index gain more than 18%, but the underlying strength of the rally began to fade during the second quarter. The lack of breadth or the concentration of strength within the market has been widely documented in the press. The Wall Steet Journal pointed out that the average stock within the S&P 500 is up 4.1% this year, while the broad index is up 14.5%. That is the largest underperformance since at least 1990, according to Dow Jones Market Data³. In other words, a few stocks are doing much of the lifting while most are taking a water break! To be clear, this lack of breadth makes sense to us as it reflects a more challenging economy. It is important to acknowledge that Nvidia’s (NVDA) recent success reflects the company’s increased profits, but it is still incredible to think that the stock added one trillion dollars in value in less than four months.
Circling back to the long and variable lags comment mentioned above, the ultimate question is, will the economy (and inflation) slow enough but not too much? Equities can handle and some cases appreciate a slowdown, but recessions get messy. History tells us that it is a difficult needle to thread. Unlike the equity market where current leadership is very narrow, certain prices remain sticky, while the broad measures of inflation have clearly cooled, so the tighter policy is working, and the economy is slowing. One of our favorite measures of the US economy is the ISM Service Index, which reflects this slow down, but it is approaching recessionary levels. We have been of the view that slower or lower inflation will come at a cost, some of which we can clearly see today, but we know others are still to come. This slower economy has narrowed the list of winners in the market, but we are working hard to navigate it.
Tyler Pullen, CFA
Portfolio Manager
Chart source: FactSet. Past performance does not guarantee future results. Market conditions can vary widely over time and can result in a loss of portfolio value. In accordance with the rules of the Securities and Exchange Commission, we notify you that a copy of our ADV, Part 2A and 3 filings with the SEC is available to you upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.
¹ S&P Global, US banks' construction loan delinquencies hit highest level in at least 3 years, 5/8/24
² WSJ, It’s Home-Building Season, but No One Is Buying Lumber, Dezember, 6/30/24
³ WSJ, No Nvidia in your Portfolio? You’re Just Toast, Grant, 7/1/24