Video Commentary: Unresolved

Unresolved

After spending a week, traveling the Western United States on two wheels, I’ve returned to note that markets are unresolved. What does this mean? The stock market has traded in a narrow price range for several months. Interest rates have moved lower, though too have also traded in a narrow range.

The S&P 500 stock index has traded between 3800 and 4200 since the beginning of the year. The 10-year Treasury has traded between a yield of 3.25% and 3.75%. While returns are positive year-to-date, the resolution of a few major items may leave markets in a very different mood.

Debt Ceiling

The United States has a debt problem. And it needs to pay its bills. These are two different issues, conflated every time the debt ceiling comes up. Raising the ceiling allows Congress to pay bills for things already spent. However, because deficit spending and tax revenue issues aren’t resolved during budget negotiations, the ceiling becomes a political football, leaving global investors to wonder if the U.S. will default on its obligations.

The impact of this back and forth can be significant. We’ve seen the stock market sell-off significantly in the past when the issue goes unresolved until beyond the final hour. Interest rates are likely to move higher and bond prices lower.

The fact that both parties have a very narrow margin in the Senate and House make the resolution more difficult. Republicans want spending reductions and Democrats want tax hikes. Neither of which have anything to do with the debt ceiling. In addition, they both have small factions willing to hold up the process to get something out of the dealings.

Treasury Secretary Janet Yellen has indicated that the Treasury will run out of special capabilities near June 1st so time is of the essence. Until this is resolved, markets will focus almost exclusively on the outcome.

New Leadership

The S&P 500 Index is up over 9% since the beginning of the year. Leading the market, are a handful of stocks like Apple and Microsoft. In fact the top 5 stocks by size represent most of this year’s gain. These are considered “growth” stocks because they have characteristics of growing revenues at an above market average pace. We don’t normally think of growth stocks as safe havens. This time seems different. And why not! Apple has a $2 trillion market cap, almost $200 billion in cash and likely the most notable brand on earth. Microsoft has software that drives the majority of computers, a phenomenal cloud and gaming business as well as their new investment in artificial intelligence.

As I noted, without tech leadership, the stock market would be flat, reflecting the unresolved nature of the biggest issue we now face. The potential for a recession.

When Will We Recess?

I ask the question when not if. While there are elements of our economy that appear to support a slow growth rolling recession, it still seems likely, to us, that we’ll have a regular economic contraction.

Investors have been worried about a recession for over six months. As we’ve noted on a number of occasions, when interest rates rise as much as they did last year, and short-term interest rates exceed longer-term rates by as much as they do, the economy generally lands in a recession.

This time appears different. For now. Why different? The pandemic of course. During the global pandemic, countries chose to close their economies, with the exception of China. In order to stem the negative effects of this, global central banks and governments injected a massive amount of stimulus in less than 18 months. Because the hole in economies was smaller than the stimulus spent to overcome it, this stimulus had two effects: it created an inflation; has much longer lasting impact on growth than would normally be the case.

Add to this that certain sectors of the economy were hurt more during the pandemic than others and they are late recovering. The best example is the leisure/hospitality sector. After people were told they had to stay home, they were excited to get back out and travel, see family and the world. Not surprisingly then, this sector has seen a tremendous rebound. In fact, when you look at employment strength, almost a third of it can be credited to this sector.

However, we believe that as the employment picture weakens, and the economy slows, we’ll see a pick-up in unemployment, which reduces personal income and consumption, slowing the economy further.

As a result, we remain more defensively positioned in stock and bond portfolios. In addition, holding higher cash balances when we’re getting paid 5% doesn’t seem as bad since that is within a couple of percentage points of our long-term expectations for balanced portfolio returns. For those that are used to risk, we don’t recommend more cash, rather we remain defensive and wait to seek opportunities when valuations abate a bit. The resolution of the debt ceiling issue will come sooner than the recession. For now, we’ll maintain our approach and use new information to adjust accordingly.