Gonna Fly Now?

The movie Rocky and its theme song Gonna Fly Now were released nearly 47 years ago in 1976.  The song seems rather apropos after the second quarter of 2023. Following a 7.5% move in Q1, the S&P 500^® Index rose 8.3% during Q2 despite numerous well-publicized concerns including a possible recession, an inverted yield curve, and a potential debt ceiling crisis, amongst others. Despite investor skepticism towards further upside in the market or perhaps because of it, the market resumed its climb of the proverbial “Wall of Worry” like Rocky climbing the Philadelphia Art Museum steps.

The economy’s resilience has enabled the market to continue climbing those steps. The labor market remains strong, with non-farm payrolls beating expectations for 15 consecutive months.  The ADP National Employment report showed growth of 497,000 jobs in June, nearly doubling consensus expectations with particular strength in leisure/hospitality.  The first quarter Gross Domestic Product was revised upward, growing at 2.0% despite 500 basis points (5%) of rate hikes by the Federal Reserve with the most recent meeting including the long-awaited pause in rate hikes. The Federal Reserve’s stress tests helped restore confidence in the financial banking system following the collapse of Silicon Valley Bank earlier this year. The positive stress test results also enabled banks to subsequently increase dividends and stock buybacks. The resolution of the debt ceiling crisis removed the fear of government shutdowns as both sides came to an agreement in Washington to reduce spending and suspend the debt ceiling until after the next Presidential election in 2025.  

Most importantly, inflation decelerated to 4.0% year-over-year in May, as measured by the Consumer Price Index (CPI).  While inflation is still above the Fed’s long-term target, this compares to 4.9% in April and represents the slowest inflation rate since March 2021. This enabled the Fed to pause its rate hike program.

 While the positive developments noted above helped fuel further upside for the market, several significant bear talking points remain.  Federal Reserve members have suggested that additional rate hikes may be needed before year-end as inflation remains well above the Fed’s 2% target rate.  As a result of the rate hikes, the yield curve remains inverted, reaching its deepest inversion since 1981.  We note that yield curve inversion is often a precursor to recession. Other areas of concern include narrow market leadership, with much of the S&P 500^® Index’s return coming from a small number of large-cap tech companies and an underwhelming recovery in China.

A big question in many investor’s minds is how has the economy remained so resilient.  Despite significant interest rate hikes and quantitative tightening, we note several factors that have helped support the economy. One factor is government spending on infrastructure at a Federal and state/local level has been strong due to several bills in Washington including the Infrastructure Investment and Jobs Act and the Inflation Reduction Act.  Furthermore, re-shoring is also helping to support non-residential construction, as factories and warehouses will be needed to support industries such as EVs and semiconductors.  Pent-up demand for travel and entertainment due to COVID and strong labor markets have kept consumer spending even as spending on hard goods such as appliances and furniture has subsided following a pickup during COVID shutdowns.   

The biggest question is, where do we go from here?  Volatility as measured by the VIX^® Index has dropped into the low teens suggesting there may be some complacency following the first-half rally. Recent commentary from Fed Chairman Powell also suggests the likelihood of up to two additional 25 basis points (0.25%) hikes this year.  Continued strength in the labor markets could make that more likely. This could provide some headwinds to the market in the near term.  Following any near-term market consolidation, we believe there could be further upside if inflation continues to moderate and the Fed concludes its rate tightening cycle.  

Though we do not know the timing or depth of any market retracement, we thought it might be instructive to look at the U.S. Leading Indicators and associated market returns from the trough to gauge where the market could go in the next six months to one year.  Our central bankers and policymakers use the U.S. Index of Leading Indicators to adjust monetary and fiscal policy.  At the moment, the Leading Indicators are quite negative, as seen below, reaching the fourth lowest period in the past thirty years. The three other negative periods include the Tech Bubble, The Great Financial Crisis and the COVID shutdowns.  While this is rightfully concerning, given the company that the current period finds itself, it also shows the level of negativity that is already embedded in these numbers. 

We thought it might be insightful to look at the annualized returns in the next six and twelve-month periods following the trough in the leading indicators.  We found that the market returned 10.99% and   -20.49% in the six and twelve-month periods following the Index’s trough on September 28, 2001. However, market returns were much higher following the troughs on March 31, 2009 and April 30, 2020 with the market returning 34.02% and 13.29% respectively for the six-month period and 49.77% and 45.98% for the twelve-month periods. While it is difficult to say whether we have reached the trough this time, it does suggest that there is the potential for further upside when we do reach trough levels.

 Source FactSet, Inc.:  U.S. Index of Leading Indicators from 1993 to 2023.

The problem, though, as a former colleague once said, is that we don’t have a crystal ball.  Therefore, we continue to manage your portfolios for the long term and utilize in-depth economic and company research as we seek to provide strong risk-adjusted returns. We look for opportunities to take advantage of any pullbacks and take profits if stocks become extended.  As always, we encourage you to reach out to us with questions or concerns.

We hope that you enjoy your summer.

Sincerely,

Peter J. Connors, CFA

President

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