Market Update

The S&P 500 rose 3.5% last week to end at 4,109.31. The Nasdaq rose 3.4%. We wrote last week that, “The stock market may rally this week on hopes that the Fed is one hike away from the end of its rate hike cycle.” It did exactly that after a back-and-forth start. Monday was a modest up day and Tuesday was a solid down day. Wednesday saw the S&P gap up at the open and not look back. The index gained 1.4% Wednesday, 0.6% Thursday, and 1.4% Friday. It closed less than 2 points from its high for the week. The action last week points to more gains ahead for the index in the short term. Next resistance is 4,200 followed by 4,325.

We wrote last week that, “It is unlikely that the rally will be sustained. The S&P appears range bound between 3,800 and 4,200 for now.” We don’t expect the S&P to climb above 4,325 any time soon. Earnings estimates are too high still. The turmoil in the banking industry only puts more pressure on earnings. Banks struggle to make money when their cost of capital is rising. An inverted yield curve makes it worse. Cost of capital is rising because depositors are fleeing to higher-yielding investments. Banks will have to pay more to depositors if they hope to stem the tide.

The problem is that banks own a lot of low-yielding investments. The Treasury bonds banks bought by the truckload with excess reserves pay little. Many of those bonds are longer term and won’t mature for years. Bank earnings are bound to take a hit.

It’s not only bank earnings estimates that are too high. Analysts are expecting Q1 earnings to decline by 7.4%. They expect earnings to fall another 5.8% in Q2. Earnings fell 1.7% in Q4 of last year. Those estimates aren’t the problem though. The problem is that those same analysts expect earnings to catapult 10.5% higher in Q4 of 2023 and rise by 12.0% in 2024.

There is little chance of earnings rising by that much if the economy falls into recession. There is little chance the Fed will cut interest rates if the economy doesn’t fall into recession. The market seems to be pricing in exactly that scenario though. The CME FedWatch Tool has the probability of a rate hike in May at only 48.4%. Futures are showing an 89.6% probability of the fed-funds rate being lower than the current 4.75% - 5.0% by year-end. Goldman Sachs places the odds of a recession in 2023 at only 35%.

Meanwhile, inflation is still running hot, and the economy has yet to weaken. The Atlanta Fed GDPNow forecast is estimating GDP growth of 2.5% for Q1 2023. The Personal Consumption Expenditure index (PCE) is still twice the Fed's target rate. The trimmed mean PCE (the Fed’s preferred measure) one month annualized rate was 4.0% in February. The Fed may pause in May. But it’s hard to imagine they’ll start cutting with inflation running hot and the economy not in recession.

So, it seems unlikely that the market will get what it wants. And that means it is unlikely we’re in for an extended run to the upside in stocks. Expect upside testing to 4,325 in the next few weeks. A fall back to 3,800 in the next few months is likely as earnings estimates come down. A retest of October’s low of 3,491.58 by the fall is more likely than a run at the 4,818 all-time high.

Economic Indicators

Economic indicators last week pointed to an economy that is growing at trend. The Atlanta Fed GDPNow forecast is estimating growth of 2.5% for Q1. The second revision for Q4 GDP was 2.6% down from 2.7%. The two quarters show that the economy is chugging along with no signs of recession yet.

Initial jobless claims showed no signs of weakening. Jobless claims came in at 198,000 down from 191,000 last week. Still under 200,000 and still indicating a strong jobs market. The jobs report comes out Friday. The forecast is for a 235,000 increase in jobs, which would be strong. The unemployment rate is expected to remain near its 50-year low of 3.6%. The JOLTS report is expected to show 10.5 million job openings, down from 10.8 million. That’s still 1.8 jobs per job seeker.

The Fed may not hike in May but it’s unlikely it will cut this year without a sharp slowdown in the economy first. The high inflation rate makes that almost a certainty. Core PCE was 0.3% in February. Core PCE year-over-year was 4.6%. Wage growth was 6.1% in February. Wages are the largest cost to businesses. Companies will try to offset rising wages with higher prices. The Fed is paying particular attention to the rate of wage increases.

Buying Fixed Income

I’ve had several inquiries about money market funds in the last few months. I’ve also recently seen several prospect portfolios that held individual bonds. Fixed income doesn’t get much airtime compared to stocks. People love to talk about and invest in stocks. Bonds and other fixed-income investments, not so much. Stocks are the glamor and fixed income is the dross of the investing world. But fixed income is an important component of an investor’s portfolio, especially older investors. There are things everyone should know about investing in fixed income. Interest rate risk is one of them.

Rising rates sent bonds lower last year. The iShares Core U.S. Aggregate Bond ETF (AGG) lost 13.0% in 2022. The index is composed of Government bonds (42.61%), corporate bonds (24.2%), and Securitized bonds (28.15%). The ETF is 100% investment grade. No high-yield exposure at all. In other words, not much credit risk. So, it bears repeating that the AGG was down 13.1% last year. What happened?

Interest rates rose. Yield up bond price down as the folks at Bloomberg like to say. It’s basic math. A bond pays a coupon. A 3% coupon means that a $100 face value bond pays $3 annually in interest. Rising rates make the 3% coupon bond’s price drop because an investor will no longer pay full price for a 3% coupon bond. They will pay the price that gives them a 4% yield if new bonds are yielding 4%. The 3% coupon bond price will fall until it yields 4%. Falling bond prices due to rising interest rates is interest rate risk.

Interest rate risk has been high since March of 2020 when the entire yield curve fell below 1%. Why? Because it was a certainty that yields would rise and prices fall. It was only a question of when. Norwood Economics sold most of its bond exposure in March of 2020.

We’ve been buying this year. The Schwab value advantage money market fund has a 7-day yield of 4.69%. In Schwab’s words, “The investment seeks the highest current income consistent with stability of capital and liquidity.” Further, “The fund invests in high-quality short-term money market instruments issued by the U.S. and foreign issuers.” Money market funds hold the share value steady at $1. The yield fluctuates with the yields of the underlying investments. Investors who need liquidity should consider money market funds. The price doesn’t change, and yields are currently over 4.5%. (Norwood Economics is not recommending SWVXX.)

Norwood Economics has also been buying short-term Treasuries. We don't buy individual bonds. We buy index ETFs. We've also been buying short-term Inflation Protected Treasuries. We use index ETFs for broad exposure to the asset class. The short-term Treasury ETF is yielding approximately 4.84% (YTM). The Inflation Protected Short-term Treasury ETF is yielding approximately 4.36% (YTM). Both ETFs share price will fluctuate with interest rates. (Norwood Economics is not recommending short-term Treasuries or inflation-protected Treasuries).

One last thing to know about bond investing. Buying individual bonds means paying markups to the broker. There is no bond market in which a bid-ask spread is public knowledge. Bonds are sold to clients out of inventory. The markups are why Edward Jones, Raymond James, Morgan Stanley, and the rest of the gang love selling individual bonds to clients. They get to markup the price of the bonds with the customer rarely the wiser. The smaller the transaction the larger the markup. Yes, there are some advantages to owning individual bonds instead of bond ETFs or funds. But unless you’re buying in size and can shop around, you are better off avoiding individual bonds.

Bonds have earned nothing for three years. The Bloomberg US Aggregate Intermediate index is down 1.96% annually over that period. Interest rates are likely close to peaking though. The Federal Reserve will probably begin an easing cycle in 2024. Capital gains should be available to bond investors during the next easing cycle. Money market funds are worthy of consideration as well. That's true whether investors need liquidity or not.

Bonds should do fine over the next few years. Longer-term, inflation will likely make bonds only a so-so option. Buy and hold probably won’t produce the best results over the next 10 years or so. Most investors should use ETFs and funds for exposure and avoid the hidden markups.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist