Weekly Recap:

Last week Fitch Ratings became the second credit rating agency to downgrade the sovereign rating of the United States one notch from AAA to AA+ (the first was S&P in 2011). While arguably of no real concern in terms of a direct impact on US borrowing costs, this move did dampen sentiment and may have contributed to lower stock and bond prices.

Meanwhile, the Treasury yield curve steepened last week due to a combination of supply technicals and macroeconomic data. At the front end of the curve, rates were lower on the week after dropping significantly on Friday thanks to a soft(ish) nonfarm payroll report. Futures markets discounted the probability of another rate hike this year, while 1y Treasury yields fell 8bp and 2y yields dropped 9bp.

Conversely, rates rose in the belly and long end of the curve thanks to the announcement of greater-than-expected supply of new borrowing from the US Treasury, which in turn contributed to P/E multiple compression, sending stock prices lower.

The most significant macro data last week was the monthly nonfarm payroll report from the Bureau of Labor Statistics. While unemployment remains near historic lows, the report was slightly softer than expected on balance:

* Change in nonfarm payrolls = +187k vs. consensus of +200k (net 2m revision -49k)

* U-3 Unemployment = 3.5% vs. previous month 3.6%

* U-6 Underemployment = 6.7% vs. previous month 6.9%

* Average hourly earnings = +0.4% m/m (prior month was also +0.4%)

* Average weekly hours = 34.3 (down 0.1 from prior month of 34.4)

Albion’s “Four Pillars”:

Economy & Earnings

The US economy showed resilience in the first half of 2023, and Wall Street analysts expect full-year corporate earnings to be roughly flat y/y. Albion’s base case expectation is that the US economy will enter recession in the second half of 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 19x is above the long run average, so valuation could be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.

Interest Rates

Rates rose dramatically in 2022 due to a sharp pivot in monetary policy, and have remained elevated in 2023 as progress on inflation has been slower than hoped. Futures markets now imply that the Fed Funds overnight interest rate will remain unchanged at 5.25-5.50% until at least March of next year.

Inflation

After reaching 40yr highs in spring of 2022, inflation has moderated somewhat over the past 12 months. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged.

Weekly Recap:

Better-than-expected inflation data drove rates lower across most of the curve last week, which in turn facilitated P/E multiple expansion and sent stocks higher.

The party got started in earnest on Tuesday, when core and headline CPI both came in below expectations for the month of June. Closely watched core CPI was just +0.2% m/m and fell to +4.8% y/y, while headline CPI also printed at +0.2% m/m and dropped to +3.0% y/y thanks to much lower energy prices relative to this time last year. See the Chart of the Week for a time series of the y/y change in core and headline CPI.

Further upstream, PPI printed at +0.1% m/m across the board (headline, core, and ex trade), with headline PPI nearly entering outright deflation territory for the first time since 2020 at just +0.1% on a y/y basis as well.

The inflation news sent rates lower across the curve, and the likelihood of a second additional rate hike before year-end flipped from odds-on to odds-off (a single 25bp hike at the July meeting appears all but assured at this point).

P/E multiples flexed up on falling discount rates, pushing most US equity benchmarks higher by 2-3% with duration-sensitive growth sectors outperforming. International stocks also outperformed, but continue to lag the US on a YTD basis.

Albion’s “Four Pillars”:

Economy & Earnings

The US economy showed resilience in the first half of 2023, and Wall Street analysts expect full-year corporate earnings to be roughly flat y/y. Albion’s base case expectation is that the US economy will enter recession in the second half of 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 19x is above the long run average, so valuation could be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.

Interest Rates

Rates rose dramatically in 2022 due to a sharp pivot in monetary policy, and have remained elevated in 2023 as progress on inflation has been slower than hoped. Futures markets are currently pricing 1-2 additional 25bp rate hikes over the summer, with no rate cuts expected before year-end.

Inflation

After reaching 40yr highs in spring of 2022, inflation has moderated somewhat over the past 12 months. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged.

Weekly Recap:

Last week was a tough one for stocks and bonds alike, as resilient labor market data lent support to the Fed’s “higher for longer” interest rate road map:

• JOLTS job openings remained historically elevated at 9.8 million
• ADP employment change nearly doubled m/m at 497k for May
• Nonfarm payroll growth of 209k in June was the 30th straight month over 200k
• U-3 unemployment fell 10bp to 3.6%
• Average hourly earning growth accelerated to +0.4% m/m and +4.4% y/y

Minutes from the June FOMC meeting were also released last week, and painted a picture of a less unified committee than the unanimous decision to pause might have suggested. Some committee members had advocated for raising rates by another 25bp, specifically because of the historically tight labor market.

The combination of somewhat hawkish meeting minutes and the ensuing strong labor market data has convinced most investors that another 25bp rate hike is coming at the FOMC meeting later this month. Meanwhile, the belly and long end of the Treasury curve shifted higher by ~20bp as investors recalibrated their longer term inflation and interest rate expectations, pushing the entire curve above 4% for the first time since October/November of last year.

The incrementally more hawkish outlook for monetary policy pushed equity prices lower as well. The selling was broad-based across sectors, market caps, and geographies, with most US and global benchmarks down 1-2% on the week.

Albion’s “Four Pillars”:

Economy & Earnings

The US economy showed resilience in the first half of 2023, and Wall Street analysts expect full-year corporate earnings to be roughly flat y/y. Albion’s base case expectation is that the US economy will enter recession in the second half of 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 19x is above the long run average, so valuation could be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.

Interest Rates

Rates rose dramatically in 2022 due to a sharp pivot in monetary policy, and have remained elevated in 2023 as progress on inflation has been slower than hoped. Futures markets are currently pricing 1-2 additional 25bp rate hikes over the summer, with no rate cuts expected before year-end.

Inflation

After reaching 40yr highs in spring of 2022, inflation has moderated somewhat over the past 12 months. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged.

Weekly Recap:

Stocks moved lower last week on a cocktail of soft economic data and a reminder from Jerome Powell that the Fed is not done raising interest rates. On the latter point, Powell testified before the US Senate Banking Committee that “it will be appropriate to raise rates again this year, and perhaps twice.” Fed fund futures have not yet bought into the notion of multiple additional rate hikes this year, but are now taking Powell at his word that there will be one more, and the no rate cuts will occur until at least early 2024.

Macro data was mostly weaker last week, with one exception: housing. Residential building permits rose to nearly 1.5 million, while housing starts jumped to more than 1.6 million, with significant increases in both single-unit and multi-family. Absent a recession, it increasingly appears that the cyclical trough in US housing activity may have occurred around the start of this year.

Otherwise, macro data released last week was not encouraging. Initial jobless claims printed at 264k, pulling the 4-week moving average above 250k for the first time since November of 2021. Meanwhile, S&P Global’s US Composite PMI slipped sequentially in the preliminary June reading, with m/m declines in the manufacturing and services components. And finally, the Conference Board’s Leading Economic Index (LEI) fell sequentially for the 14th consecutive month.

The consequence of all this was a broad-based pullback in US stocks, with cyclical sectors (industrials, materials, financials, and energy) all underperforming as the nearterm direction of the economy became the primary concern.

Albion’s Four Pillars:

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but growth has slowed in early 2023 and corporate operating margins have fallen as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 19x is above the long run average, so valuation could be a mild headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.

Interest Rates

Rates rose dramatically in 2022 in response to a sharp pivot in monetary policy, and have remained elevated in 2023 as progress on inflation has been slower than hoped. Futures markets are currently pricing one additional 25bp rate hike over the summer, with no rate cuts expected before year-end.

Inflation

After reaching 40yr highs in spring of 2022, inflation has moderated somewhat over the past 12 months. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged.