Soft Landing... So Far

July 2023

After a down year in 2022 for both stocks and bonds, 2023 has been a good rebound.

When the handful of bank failures occurred in March, most market watchers thought the Fed would stop raising raising rates and that a credit crunch would start a recession. Instead, we got better economic data and a rally in large cap tech stocks.

Fed Chair Jay Powell is looking smart, as inflation is trending lower and jobs are still growing. The criticism of Washington’s recent policies has all but stopped.

Stocks are clearly bullish on the economy. Maybe the AI productivity boom that we discussed in last quarter’s letter is upon us.

However, bonds and leading economic indicators are telling us recession will be here soon.

The bond market has a compelling track record here. When the blue line crosses the horizontal black line, it’s because short term bond yields are higher than long term yields. That happens when institutional bond investors feel “times” are going to get worse before they get better. As you can see, every time the blue line dips below the black line, a recession follows about a year later. We are there now.

Importantly, if we do have a recession in the next year, it does not mean stocks have to go down. One reason there is so much optimism in the stock market right now is because historically, when rates stop going up, investors look forward to stable or cheaper borrowing costs. That relative improvement, coupled with the long term growth of stocks, is all the justification some stock investors need to commit capital.

I respect both stocks’ ebullience and the bond market credit analysis.

+Inflation is coming down

+Fed rate hikes are about done

+Technology and AI may be on the cusp of another era of productivity gains

-Commercial real estate and bank loans are a mess

-The student loan moratorium is ending

-Mortgage rates are up from 3.5% to 7% - that takes a mortgage ($350k) on a median home ($437k), after a 20% down payment ($87k), from a monthly payment of $1560 to $2330. That’s a lot of money to a lot of people. This also applies to corporate borrowing expense, government borrowing expense, and consumer credit card interest.

-Retail spending is starting to turn negative

Core inflation is still above 4%. The Fed has said clearly that they plan on raising rates until that inflation is closer to 2%. Raising rates so much in such a short time is just starting to be felt.

Therefore, if stocks keep rising in the third quarter, in tax-deferred accounts I’m inclined to take some stocks off the table and add to our bond positions, most likely international bonds.

Sincerely,

Chip