The technical definition of a bear market is a rather arbitrary label that comes from the S&P 500 20% or more off its high print. We got there last week. A similarly arbitrary definition of a recession is two quarters of negative GDP growth. Many economists think we are going by the time numbers come in for quarter two this year. Whatever label you put on it, things are looking pretty rough. Gas prices are up, food prices are up. Stock prices and real estate prices are finally down. That’s the reality of asset markets – of course the million-dollar question is – where do these prices go from here? Is this just a pullback as the world economy gets back on track after the corona virus and lockdowns that have continued in Asia? Will the Ukraine/Russia conflict be resolved so people can get back to work?
One lingering question is if the economy is so good and things are running so hot that the Fed has to raise interest rates, then why is the market slumping so severely? Or is the market slumping because the Fed is raising rates and removing its stimulus? We are regularly skeptical of the Fed – even the concept of the Fed – but that is what we have to deal with.
So one of the indicators that we mentioned a few weeks ago was the differential between junk bonds and treasuries. In short, this is the difference in interest rates that higher risk corporations have to pay to borrow money vs the no risk rate that the government has to pay to borrow money. We mentioned that the spread was remarkably low. This is an important indicator of the credit market – which tends to lead the stock market - and things looked surprisingly good. However, over the last few weeks the strength of junk bonds has deteriorated and not so in treasuries. So, the spread between the two is stretching out to the point we are taking notice. Here’s a visual of that “spread” over the last few years.
Again, this spread shows when credit markets are getting nervous about the future economic strength, and we are seeing some concerns. This high yield/treasury spread was higher in late 2018 but not much. This returns us to the question of what the Federal Reserve will do in the near future. Market participants are predicting another .50% hike in short term rates by the Fed at their meeting in June. But some economic numbers are coming in much lower than just a few months ago. New home sales and permits to start have come WAY down. Employment data has dropped quite dramatically according to recent surveys. Big box retailers (think Walmart) have had a CRAZY whipsaw in inventory to sales ratios. One year ago, there was very little inventory and good sales after retailers were coming out of COVID lockdowns. Now we have had a rocket launch in inventories and a decline in sales. Consequently, shipping rates are dropping quickly. Is this a DEFLATIONARY force exerting itself? Will the Fed look at new data between here and June and maybe reconsidering its aggressive hike plan? Have the credit markets priced in the hike already and would firm up if the Fed did ease off its hiking? The Federal Reserve – even to their own admission – drastically overstimulated the credit markets and the economy. The Fed is backed into a corner trying to make sure credit markets and asset markets can be cooled off without being crushed. They now say that a soft landing as they are pulling back some of this stimulus may be beyond their control. Great…
The stock market has been down seven weeks in a row for the first time since 2001. Friday looks like at least a short-term bottom to us as things have gotten overly negative. We expect a relief rally. Going forward, we can only guess as to the actions of the Federal Reserve – so preparing an investment strategy based on what they will do is not a good idea. Of course, we hope the Fed doesn’t ignore economic data and blindly raise rates until something breaks – but we doubt they will DRASTICALLY change from their tightening schedule unless something does break. (a quick guess is that they only raise rates .25% in June, but we will see.) So, if the movement of markets is keeping you up at night, raise some cash on the relief rally adjusting your portfolio to less risk. But we have been saying that for weeks now https://www.sesweb.net/blog/canary-in-the-coal-mine
When credit markets show that they are on firmer footing we will have more confidence with risk on – but there will likely continue to be volatility.
Regards and good investing,