This is a brief overview of Cumberland Advisors’ thoughts on the second half of 2023 and a look back at the first half of this year. As we mentioned in January, one of our basic investment tenets is that markets revert to the mean over periods of time.
Economic Outlook – David Berson
As of midyear, the economy continued to grow, although the pace has clearly slowed. Still, real GDP growth is positive; changes in nonfarm payrolls remain above trend rates; unemployment rates remain near the lowest levels since the 1960s; and consumers are becoming a bit more optimistic. But despite these positives, we continue to think that the odds of a recession remain better than 50 percent over the next year – although perhaps a recession is more likely at the start of 2024 than in the remainder of 2023.
The Federal Reserve has tightened monetary policy significantly over the first half of this year (see commentary from Bob Eisenbeis, below), with a high likelihood of another 25-basis-point hike in the federal funds rate at the end of July. This hike, if it happens, would further invert the already significantly inverted yield curve, with short-term rates even more above long-term rates, something that usually occurs before economic downturns. But the probability of more Fed tightening (beyond July) has declined recently as inflation has receded. The June Consumer Price Index (CPI) release showed the slowest gain in the 12-month trend rate since early 2021, at 3.0 percent. Moreover, the trend rate in the core CPI (the total less the volatile food and energy components) moved lower to the slowest rate since late 2021, at 4.8 percent. These measures remain above the Fed’s long-term goal of 2.0 percent, and it is not clear if the Fed will respond more to above-goal inflation or to the sharp drop toward the goal.
But even if the Fed moves only one more time (at the end of July), the magnitude of monetary policy tightening that has already occurred is probably sufficient to cause at least a modest recession. The positive, if slowing, momentum in economic growth suggests that any downturn is unlikely in the current quarter. But monetary policy works with long and variable lags, with the main impacts of Fed tightening occurring 12–18 months after a tightening cycle begins. With the Fed having started to tighten in March 2022, but not really pushing rates significantly higher until May of last year, the largest negative impacts from tighter policy won’t be felt until the second half of this year.
If a recession does occur later this year or early next year, the likely impacts would be a rise in unemployment rates, declines in corporate earnings, lower interest rates, and a further (perhaps sharp) drop in inflation. How long and how sharp such a potential economic downturn would be is still highly uncertain, but the lack of significant sectoral imbalances (such as with housing and mortgage markets in 2007) suggest that the next downturn won’t be severe. But how the Fed responds is also important, and that will depend in part on the behavior of inflation. If inflation falls below the Fed’s goal quickly as the economy slips, it will allow the Fed to change course sooner – pushing interest rates even lower faster. But if inflation remains sufficiently above the Fed’s 2.0 percent goal after a downturn starts, the Fed may be less willing to combat the recession with expansionary monetary policy, at least initially – perhaps prolonging the downturn. But at some point, inflation will fall by enough for the Fed to ease, helping the economy to grow again with lower interest rates and a new pickup in corporate earnings.
It is still possible, of course, that an economic downturn is not on the horizon. Instead, a soft landing for the economy would allow for modest economic growth and lower inflation. Soft landings have occurred in the past, but they are rare, and we think the odds of one occurring in this cycle are still relatively low – although perhaps a bit higher than we thought six months ago.
The Fed – Bob Eisenbeis
The June minutes of the FOMC meeting, at which the Committee paused raising rates, revealed the reason for the pause: considerable concern about how much past policy moves were being reflected in the current data and how much of that tightening remained to be reflected in future data. The Summary of Economic Projections showed that 9 of the 18 participants saw two more rate increases this year, while 3 saw more than that, 4 saw only one more increase, and 2 saw no more increases in 2023. This uncertainty provided much of the rationale for the committee’s focus on incoming data rather than on forecasts per se in formulating future policy moves and was also mirrored in the description of the economy contained in the minutes.
While the economy grew at a modest pace, the job market remained tight; job gains were robust; and inflation remained elevated. In terms of the outlook, while the Fed staff noted considerable uncertainty about the forecast, in part because of substantial potential effects of developments in the banking sector, it saw the possibility of continued growth that would prove sufficient to avoid a downturn. The minutes read: “On balance, the staff saw the risks around the baseline inflation forecast as tilted to the upside, as economic scenarios with higher inflation appeared more likely than scenarios with lower inflation and because inflation could continue to be more persistent than expected and inflation expectations could become unanchored after a long period of elevated inflation.” It seems clear that these upside inflation risks lie behind the projections of two more rate increases in 2023.
Equity Markets – David Kotok
While the first half of 2023 was marked by bank failures, Russia’s bizarre mutiny, the war in Ukraine, and the Fed’s tightening policy focused on tamping down inflation, the second half of the year will begin to see the political season intensify as the 2024 election cycle approaches. Whether a political event becomes market moving is uncertain. Until now, market agents have mostly ignored politics and have seemingly assumed that 2024 will be a rematch between Biden and Trump.
For the first half of the 2023, the markets have dealt with only one political item: the debt ceiling fight. That contrived crisis was purely political, and it cost billions before President Biden and the Congress reached an 11th hour resolution. We are examining the cost of the debt ceiling fight in some detail and will write about it for our Cumberland website column. When the political drama was over, stock markets rallied and ended the first half of 2023 as if the fight had never occurred.
As the list of the almost 20 presidential candidates takes shape and the run-up to the early primaries intensifies toward the end of 2023, we expect financial markets to start paying attention to policy issues that may have an impact on business and economics. Markets tend to ignore the culture war issues. Disney stock may be an exception, depending on the outcome of the litigation between the company and Florida Governor DeSantis. Currently, market agents are mostly watching the Republicans and the Democrats sort out the challengers to the frontrunners, Joe Biden and Donald Trump. The president and former president each have clear front-runner positions in their parties, though both also carry a lot of baggage. Each is vulnerable, and each has a weakened polling position, given their respective negatives, though those revealed negatives, measured by similar polling methods, are different. We may also watch the development of the No Labels movement, as it is already well funded.
Some contrasts are unusual and were not expected a year ago. On the Democratic Party side, the anti-vaxxer Robert Kennedy, Jr., who comes with an established Democratic family name, has become a disruptive force that has to be considered. The Democratic primary calendar is, of course, still up in the air, with state Democratic leadership in New Hampshire objecting to a national party plan to make the South Carolina Democratic primary first. (See “Georgia and New Hampshire’s places in limbo as Democrats hammer out 2024 primary order,” https://apnews.com/article/democrats-dnc-primary-calendar-new-hampshire-georgia-d5d6c5483a9bee50d5b43cf5ac75e2a1.) As this is written, we have no idea how the NH primary will shape up in either party. But Robert Kennedy, Jr., is likely to run in that primary, and we do know that New Hampshire is still going to be the focus of national attention immediately following the Iowa caucuses. Note that Iowa, by itself, is not very predictive of the final outcome, according to history. But when you combine Iowa and New Hampshire, the results show that, since 1976, nearly every president eventually elected won at least one of the two states. That said, the fracas over the Democratic primary calendar has generated uncertainty about whether Joe Biden will actually appear on the New Hampshire Democratic primary ballot (“Biden could lose first two ’24 contests to RFK Jr,” https://www.axios.com/2023/06/15/iowa-new-hampshire-biden-lose-2024-primaries-election). That said, New Hampshire Democrats and the national Democratic Party have until September to work things out.
Let’s look at some history. From 1952 to 1988, the presidential winner also won the NH primary of his party. That is how Dwight Eisenhower successfully eliminated the challenge of Howard Taft. In more recent years, the results have been mixed. For a history lesson about NH, see “New Hampshire presidential primary,” https://en.wikipedia.org/wiki/New_Hampshire_presidential_primary. Note that Donald Trump won NH in 2020. Also note that Bernie Sanders narrowly beat Joe Biden there in 2020.
Besides politics heating up, the usual market-moving suspects will be in line for the rest of 2023. The Russo-Ukraine War, China policy, AI development, Fed policy and inflation, and recession or no recession are some of the issues. The attack on ESG from the House of Representatives will make headlines, but the Senate is unlikely to advance any new legislation. We continue to favor the energy sector, both fossil fuels sources and solar power, in the US Equity ETF portfolio. One very certain forecast will dominate: We will get surprises. On that we can rely. The rest is the usual scenario strategy planning; but, we believe, it is always the “unknown unknowns” that make the headlines.
A local note: Florida now has three presidential candidates in the Republican primary. Donald Trump is the clear front runner in Florida; challenger Governor DeSantis is a distant second; and new addition Miami Mayor Francis Suarez is developing a Florida base while he seeks national recognition. In Florida, presidential politics is a front-page story every day.
Taxable Fixed Income – Dan Himelberger
Treasury yields continued to be extremely volatile during the first half of 2023 as market participants digested economic data and tried to time the end of the Fed hiking cycle. The net result of interest rate movements during the first half was the curve’s inverting deeper as short-term rates rose and longer rates fell. The biggest rise in rates was seen in T-bills, with the 1-month rising 114.3 bps to 5.038%. The biggest decline was seen in the 30-year, which dropped 10.4 bps to 3.862%. You can see the rest of the Treasury curve changes for that period in the chart below.
Source: Bloomberg
Spread volatility cooled, with both IG corporates and taxable munis tightening during the first half of 2023. The spread on the Bloomberg US Corporate Bond Index tightened 7 bps to +123 bps. The spread on the Bloomberg Taxable Muni US AGG Index also dropped 22 bps to +106 bps. The outperformance from taxable munis benefited our strategy during the quarter as we continued to maintain a higher weighting relative to the benchmark.
As we move into the second half of 2023, we will look to continue increasing the book yield on portfolios by swapping out of lower-book-yield securities. There was limited supply in the taxable muni space during the quarter, but supply should pick up as summer comes to an end. Our expectation is that the volatility in the market will remain high until there is more clarity on when the Fed will stop raising rates. We will continue to take a conservative approach to credit while looking to be opportunistic as attractive deals come to market.
Tax-Free Municipal Bonds – John Mousseau
The muni market saw a rebound in the first half of 2023.
It was an up and down first six months, with a January rally followed by a February fade after a stronger jobs number in early February. In March, all bonds rallied on the back of the banking crisis, which sent interest rates down on fear of greater erosion in the financial cycle. As that did not transpire outside of the banks that failed early on, we saw a gradual rise in rates towards quarter end.
Looking at the two charts below, we can see that high-grade munis inside of 7 years have seen a rate rise in sympathy with Treasuries in the short end of the curve. In the longer end of the market, we have seen tax-free yields decline slightly and become richer to US Treasuries.
Source: Bloomberg
A few things contributed to this decline.
Overall muni supply is down 15% this year from last year, reflecting issuers’ reluctance to issue at higher interest rates, as well as the fact that many issuers are still sitting in good financial condition and do not NEED to issue debt. Also, liquidations of municipal bond funds have been reduced to much lower levels, with occasional inflows. We believe that since the selloff of last year, much of the liquidation in bond funds has been money moving to separately managed accounts where yields on individual bond issues are HIGHER than those on the embedded yields in municipal bond funds.
The chart below shows the yield on the Bloomberg 10-year GO municipal bond index compared to Treasury yields for the past three years, as well as the ratio between the two. Essentially, the market has calmed down, and many investors are realizing that the 4%-plus yield on a taxable equivalent basis offers competitive returns versus equities on a risk-adjusted basis. And it’s clear that the longer-maturity part of the muni curve offers value.
In the second half of the year, we believe the key will be the continued narrative about inflation. The chart below shows the year-over-year numbers in CPI. We believe it will be HARDER for CPI to grind lower from here, as there are some lower monthly numbers from last year being replaced by slightly higher numbers this year. But we do believe the key is continued movement down in 3-month and 6-month annualized inflation numbers.
If these numbers continue to grind lower, it should set the table for positive muni performance. In addition, yields have risen enough that investors also realize that the compounding effect of higher rates has a positive effect on total returns over longer time periods, and we believe that this 4%-plus yield on the intermediate to longer end of the muni market will continue to attract interest.
Municipal Credit Outlook – Patricia Healy
We continue to expect the credit quality of municipal bonds to be stable as we head into Q3. The economy has not slowed as much as anticipated at the beginning of the year, even in the face of almost unprecedented Fed tightening with multiple interest rate hikes. The expectation of eventual lower rates seems to have postponed municipalities’ plans to issue debt – making the supply of munis much lower than anticipated while limiting debt leverage increases, which can be a credit positive. So, there may be a bump up in issuance in the second half, as funding of planned or needed projects cannot be put off indefinitely. Consumer spending has been good, with revenge travel continuing; and people appear to have become accustomed to higher prices and interest rates. The prospects for a recession have been pushed out, and expected severity has been reduced, which is good for municipal credit quality.
In the second quarter, upgrades outpaced downgrades; however, there were some negative headlines, such as Moody’s revising California’s Aa2 rating outlook to negative. The state’s revenue declined, as it is dependent on income and capital gains taxes and there was a postponement of tax due dates. At this point the stock market has improved, helping the earnings of Californians; and although the state had a substantial reserve fund, it is looking at budget cuts, too, so it can maintain a healthy reserve. Depending on how things develop, the state’s outlook could change back to stable. Issuers in many sectors, such as airports and utilities, have already experienced upgrades; thus the future pace of upgrades may be slower than in the past. And with a potential economic slowdown, the rating agencies may be more sanguine about positive rating changes.
Sectors that remain under pressure or have negative outlooks are healthcare, higher education, and transit. Wage increases have abated as more folks have entered the workforce, taking some of the pressure off, especially in healthcare. Higher education has wage issues and demographic issues, resulting in lower enrollments. Transit systems are still seeing below pre-pandemic ridership levels and depend heavily on federal and state funding. These three sectors also were very dependent on pandemic aid, and future budgeting may be challenging. That said, munis are diverse, having varied security structures and strengths. A transit system bond may be fully paid by a sales tax pledge, and public higher ed has state support, while larger, well-regarded private colleges are experiencing strong demand.
Municipalities are well positioned to address potential recession or event challenges. Elements of resiliency include healthy accumulated reserves, good budgeting and fiscal management, established rainy day funds, improved pension management, good revenue growth, improved property tax bases, and increased sales tax revenue.
__________
We thank all readers for their interest. Please remember to visit our website (www.cumber.com) to find information about Cumberland Advisors, the investment strategies that we offer our clients and partner firms, and other relevant information.
Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.
Sign up for our FREE Cumberland Market Commentaries
Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.
