Should We Turn The Air On?

Spring is here. In my house, this means the annual debate about air conditioning begins in earnest. For me, living in Wisconsin, there are three to five days a year when A/C is needed. My wife, by contrast, believes we should turn it on upon the first 80-degree day and leave it on until September 30 (or snow, whichever happens first). To make my case, I point out we live in a climate where only four months of the year feature an average high temperature above 70 degrees. And no months have an average low temperature above 70.

I will admit that this data-driven approach to making the case for open windows is not always successful. That doesn’t mean the data isn’t important, though.

The same is true with respect to recession expectations. Almost everyone agrees that a recession is imminent due to the quick hike in interest rates by the Federal Reserve, tighter lending standards and the major reduction in policy liquidity. What they don’t agree on, however, is how severe the recession will be—hard landing or soft landing?

Why does the disagreement matter? Because investors are pricing securities in anticipation of the type of economy they expect to get in the future.

Current expectations favor a soft landing … at least at first glance

If you look at stock index performance, you’d think that investors are positioning for a soft landing. The S&P 500 Index has returned over 8% so far this year. Generally, the market has traded in a fairly narrow range, which means investors are waiting for more clarity.

However, if you look more deeply, you’ll find that not all stocks have done well. An equal-weighted S&P 500 Index is up only 1.23%. To illustrate the difference, consider Apple and Exxon Mobil:

• Apple is the number-one company in the index with a market capitalization of $2.67 trillion
• Exxon Mobil is tenth at $445 billion.
• In the regular (capitalization-weighted) S&P 500 index, then, Apple counts six times more than Exxon Mobil. Apple is up over 33% since the beginning of the year. Exxon Mobil is flat.
• In the equal-weighted index, they count the same.

Now, history matters. In 2022, Apple was down 36% (right, it hasn’t moved in 15 months), and Exxon Mobil was up 80%. The key point is that technology stocks sold off in 2022 and have come back since the beginning of the year.

And why not … after all, with greater uncertainty regarding the future for economic growth, investors are attracted to a company with over $380 billion in revenue and a 25% profit margin as well as $195 billion in cash on the balance sheet (more than the annual GDP of Hungary). The tech behemoths like Apple are safe havens, kind of like the basement when mom and dad are discussing air conditioning, so it isn’t surprising that investors want to hang out there. It is possible that their rising valuations reflect the high level of economic uncertainty.

Bond yields also point toward a soft landing

Bond yields may be forecasting something similar. After rising to over 5.25%, the yield on the two-year Treasury has fallen to just below 4% in the last two months.

Since the Treasury’s yield reflects investors perspective on where the Federal Funds short-term interest rate will be two years from now, it seems bond mavens are telling us that the Fed will have to stop raising rates soon.

The current Fed Funds rate is over 5%. So, a two-year yield near 4% is telling us that the Fed will not only stop raising rates, but it’ll also reduce them. People believe that the Fed’s inflation fight will be won, and interest rates will move lower again. If this were to happen in that time frame, it would seem a softer landing is in order.

Not so fast

It is possible however, that investors are a bit too sanguine about how robust the economy can be on the heels of a 5+% interest-rate hiking cycle. Forward-looking indicators are saying that things could be worse than a soft landing.

As an example, the Conference Board’s index of leading economic indicators (LEI) has fallen precipitously, as you can see in the chart below. The blue line represents the year-over-year percent change in the LEI index. In the past, this kind of decline has resulted in a recession (those vertical grey shaded areas on the chart). Soft landings generally follow less dramatic declines. Only two of the thirteen components that make up the LEI are positive, and one of those is the stock market return, which we’ve noted is based on a few stocks.

We’ll get another peek at this indicator on May 18.

On Monday, in another bit of not-good news, the Senior Loan Officer Opinion Survey was released. The survey showed that 46% of banks tightened their loans standards for mid and large companies. In the second quarter of 2022 that number was only 24%. Small businesses saw their standards tighten too. Tougher credit standards and higher interest rates makes it more difficult for companies to invest in themselves. This could exacerbate any economic slowdown.

Debt debate

While not necessarily a long-term economic issue, the immediate debate over raising the debt ceiling will also challenge the market’s current view that everything is OK. It appears that the Republicans’ narrow margin in the House will make it harder to separate raising the debt ceiling from budget spending. To the extent a deal isn’t struck until the last minute, markets will react negatively. The likelihood of a real default is very low, yet the chance that this will be an issue until the very last minute is high.

Continuing to play defense

There are a number of reasons to suspect that a soft landing is not in the cards. We’ve continued to be more defensively positioned in both equity and fixed income portfolios and the managers we use have cash positions of their own.

We’ll keep an eye on the data as the soft-vs.-hard-landing debate continues. At home, I’ll keep an eye on the weather data to frame the debate about the use—or overuse—of A/C this summer.