News & Insights

Schrödinger’s Market

Recent equity market volatility was brought on in part by investors questioning the continued strength of the economy, triggering a global selloff in leveraged assets. This atypical economic expansion, beginning in the teeth of the pandemic lockdown, has been characterized by very narrow market leadership. This confounds strategists because market participation has not followed the typical patterns of past expansions. The unprecedented effects of the economic shutdown, coupled with massive fiscal and monetary stimulus, make an easy answer difficult, because things really are different this time. Business cycles typically experience four stages, with small-cap, value, and low-quality factors performing best early in the cycle, and high-quality, low-risk, large-cap stocks outperforming later. The lack of early-stage outperformance by small-cap or value stocks now prompts confusion as to where we are in the business cycle. Four years into the current economic expansion, a brief rally in small-cap stocks was followed by a more sustained outperformance in the S&P 500 Equal Weighted Index, which tends to be more cyclically sensitive, both typically early-cycle indicators.

Business cycles have averaged 5.5 years (though with high variability) with the last cycle stretching over 10 years. The last recession, induced by government responses to the pandemic, ended in May 2020, implying that we’re more than four years into the present cycle. As they pick through the economic reporting, there is much speculation among market strategists, economists, and investors that this economic recovery is in its late cycle, with another recession looming around the corner.
 
Despite the negative macro-outlook of many analysts, it could be said that the economy experienced a “mini recession” in 2022, perhaps resetting the cyclical clock. There was an “earnings recession” in 2022 for the S&P 500 that didn’t bottom until the first quarter of 2023, with GDP reports reflecting two consecutive negative quarters. The Conference Board’s now unloved leading economic indicators show the economy bottomed in early 2023. Bank of America’s “regime indicator” model is showing that the economy is in stage one of four for that measure of the business cycle. Even the rate of change in M2 shows that its measure of money supply growth bottomed in early 2023 and is now expanding. Bull market runs have averaged a return of 169% historically, while the current bull market, if it started in October 2022, has returned only 46%. Recent market volatility tells us that returns from this point could follow two paths: If the economy and earnings slow further than investors expect, we could be in for a continued rough ride, but if the Fed can get ahead of the slowdown, the bull market may carry on.

S&P 500 Earnings per share vs U.S. GDP

Source: Bloomberg

Conference Board Leading Economic Index six- and 12-month Rate of Change

Source: Bloomberg

Aggressive Rate Cutting Cycle Imminent

The Fed has been watching long-term inflation expectations forever. In support of near-term rate cuts, consumer price inflation has been trending down and short-term expectations are also moderating, with the 1-year inflation swap rate tumbling to below 2% from 2.8% earlier in the year. Long-term inflation expectations had barely budged this year until the recent selloff shocked them to near pre-pandemic levels.

Recent measures for long-term inflation reveal that current expectations for five and 10 years have fallen back to the upper range of where they were before the pandemic. The implied rate in the TIPS market is near 2.1% for five to 10 years, and inflation swaps are closer to 2.4% for both time periods. Consumer long-term inflation expectations have fallen below 3%. 

It remains to be seen if this drop reverses as fears wane from the recent tumult, but if it holds, this will be a big green light for the Fed to begin an aggressive rate-cutting cycle. Chairman Jerome Powell has consistently highlighted that long-term inflation expectations are a key metric for his confidence that inflation remains anchored. As the Fed’s fear of sticky inflation grew, it quietly increased its long-term neutral rate forecast. This fear abating in combination with a slowing labor market, amid several other indicators of cooling prices, should bring inflation close enough to the Fed’s target to comfortably begin a prolonged easing cycle.

1-Year Inflation Swap Rate

Source: Bloomberg

10Y Inflation Swap Rate and 5Y5Y Inflation Swap Rate

Source: PitchBook

Dislocations in the Housing Market

The U.S. housing market suffers from a dichotomy: Although pending home sales remain near all-time lows, prices have risen to record highs. The total inventory of homes for sale has bottomed out at just half the level of the pre-pandemic economy but is inching up. Existing homeowners with low-interest mortgage rates are reluctant to sell, and many prospective buyers are priced out of the market. The cost of home ownership has risen dramatically as construction costs have surged 42% since the onset of the pandemic, and the cost of rebuilding and repairing homes is high, contributing to surging insurance costs. The Housing Affordability Composite Index is near the lowest level on record, the result of high mortgage rates and home price increases that vastly exceed the growth in average incomes over the past five years.

Relief from high mortgage rates is on the way. As the Fed cuts rates and the unusually wide spread for mortgage rates normalizes from 2.56 percentage points to the historical norm of approximately 1.75, affordability will improve, resulting in both increased demand as well as improving inventories as many owners are released from their golden handcuffs. Assuming the 10-year Treasury stabilizes around the current level, both 30-year fixed and variable-rate mortgages will likely fall, lowering the cost of homeownership. We see this mortgage rate relief as the linchpin for freeing up the complex housing market to more fully function and once again contribute to growth in the economy.

30-Year Mortgage Minus 10-Year Treasury

Source: Bloomberg

Existing Home Inventory vs Case-Shiller Home Price Index

Source: Bloomberg

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This commentary is as of Aug. 14, 2024, for informational purposes only and is not investment advice, a solicitation, an offer to buy or sell, or a recommendation of any security to any person. Managers’ opinions, beliefs and/or thoughts are as of the date given and are subject to change without notice. The information presented in this commentary was obtained from sources and data considered to be reliable, but its accuracy and completeness is not guaranteed. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not indicators or guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification strategies do not ensure a profit and cannot protect against losses in a declining market. All indices are unmanaged, and investors cannot invest directly into an index. You should not assume that an investment in the securities or investment strategies identified was or will be profitable.

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