Newsletter
Dear Client,
Halfway through 2023, U.S. stocks defied skeptics and capped off a strong six months with the Nasdaq posting its best first half since 1983. Equity markets looked past numerous headwinds, ranging from a crisis in regional banks to the debt-ceiling standoff. Within stocks, there were significant divergences in performance as the rally was driven in large part by a handful of mega-cap technology names associated with the artificial intelligence craze. Bond market yield curves remain deeply inverted as investors come to grips with the idea that rates will likely remain higher-for-longer as the Fed continues to battle inflation.
The Federal Reserve has a tough road ahead of them. So far, they have been successful in getting CPI inflation down from 10% to 4% in large part due to base effects in energy prices, but to get to their 2% target, Fed Chair Powell will need to deflate the rest of the economy. The combination of substantial consumer spending out of excess savings, and strong fiscal support, has resulted in consumers and the broader U.S. economy insensitive to rate hikes, prompting the Fed to hike faster and further. As excess savings dwindle through the balance of this year and the fiscal impulse declines, the economy will become far more vulnerable to the existing high level of the underlying real Fed funds rate. While it is outside of the Fed’s “dual mandate,” credit conditions and liquidity in the financial system are increasingly critical factors in the Fed decision making process. The liquidity backdrop is starting to deteriorate as a result of record levels of Treasury issuance and quantitative tightening (QT), while fiscal support is expected to reverse in the near-term with the expiration of multiple government programs. In the first half of the year, the drawdown of the Treasury General Account offset QT to a large degree. In the second half, QT, a rebuild of the Treasury General Account, and shrinking bank lending will tighten liquidity.
The labor market has proven to be resilient, hiring slowed in June but wages rose and unemployment fell, likely keeping the Fed on course to raise interest rates later this month to combat inflation. This robust wage data helped send 10-Year and 30-Year U.S. Treasury yields to their highest levels of the year, and 2-Year and 5-Year rates to the highest levels since 2007. The U.S. Economic Surprise Index tracked by Citi, which measures how much incoming economic data deviates from expectations, has risen to its highest level in more than two years. This adds to the burden of Fed policymakers who are trying to cool down the economy without breaking its back.
Investors have a lot to decipher as they position for what lies ahead. Markets have come around to the idea that central banks will not quickly ease policy. Swap contracts linked to future Fed decisions are almost fully pricing in a quarter-point increase on July 26, and about 50% odds of an additional hike by year-end. Market participants should expect volatility into the fall as the ultimate effects of quantitative tightening, cumulative interest rate hikes, and evaporating liquidity are unknown. This environment is not conducive to a lasting bull market in equities and we conclude that at this stage, investors should prioritize valuation and balance over risk-taking. We emphasize broad diversification within equities and high-quality fixed income at this juncture.
Regards,
Edge Wealth Management
Past performance does not guarantee future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product directly or indirectly referenced will be profitable, equal any corresponding indicated historical performance level, or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. This content does not serve as the receipt of, or as a substitute for, personalized investment advice from Edge Wealth Management, LLC. If you have any questions about the applicability of any content to your individual situation, we encourage you to consult with the professional advisor of your choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request or by selecting “Part 2 Brochures” here.