Need-to-Know Topics

• Debt ceiling negotiations are still underway. We’ll probably see a last-minute deal as both sides will want to put on a good political theater performance.
• The current economic environment is facing many crosswinds, making it difficult to be either optimistic or pessimistic.
• The market is expecting rate cuts this year, the Federal Reserve is saying, not so fast.
• The S&P 500’s returns since March have been largely driven by a handful of companies. The rest of the S&P 500 will have to catch up for the market to move higher this year.
• We are still positioned defensively in our strategies but are expecting opportunities over the summer.

Debt Ceiling Negotiations or Political Theater, is There a Difference?

As of this writing, D.C. is still embroiled in negotiations regarding the national debt ceiling. As you may know, the debt ceiling debate is not on the debt that the U.S. already has, but on future debt that it will need to raise to fund the national budget. We believe there is little to no likelihood that President Biden, or Congress, will allow the U.S. to default. It would be political suicide for all the politicians in D.C. and an extremely negative event for the U.S. If there is something that would cause the rest of the world to question the stability of the U.S. dollar, it would be the U.S. defaulting on its outstanding debt.

It is our baseline case that D.C. will be negotiating until the last minute and then announce some sort of deal. It seems they are leaning towards creating a deal that may last less than two years, but it is very possible that they will come away with some kind of extension until the fall when they will go through the process all over again.

The market will get increasingly jittery as we get closer to the June 1^st default deadline Treasury Secretary Yellen gave. Negotiations will have to be settled by the end of this week to make sure there is time for Congress to vote on the bill, assuming there is no wiggle room in Secretary Yellen’s deadline. We expect once a bill gets announced there will be a relief rally which will drive the market up. However, we won’t allow any brief rallies to make us complacent, there will be plenty of obstacles in front of the economy over the next few months.

Crosswinds Make Navigating Difficult

There are all sorts of “wind” words we like to use in our business: headwinds, tailwinds, crosswinds, etc. Headwinds winds are bad, tailwinds are good, and crosswinds usually mean there is conflicting data being released making it difficult to have a clear picture of where the economy is headed. There has been a slew of mixed data over the last few months that points to the economy going into a recession and points to an economy that continues to chug along:

• Manufacturing production is at a level not seen since the COVID shutdown.
• New building permits are down 21% compared to a year ago.
• Personal savings rates are down to 4.8% (the long-term average is closer to 8.75%).
• Credit Card debt is the most it’s ever been, recently surpassing $1 trillion.
• Bank lending is slowing down and tightening lending standards across the board. This makes it harder for small business to fund their operations and lessens capital available to consumers for major purchases.
• Core inflation is receding, but still stubbornly higher than the Federal Reserve wants to see it.

These are all data points that lead to a slowing economy, if not a recession. However, there is plenty of data to support a resilient economy that may be able to save itself from a recession.

• Rental prices have been moderating and home values have fallen nationwide. This will be reflected in the core inflation reading over the next several months, which will help bring core inflation down. Something the Federal Reserve desperately wants to see.
• The number of job openings available has reduced from the high of last summer (also something the Federal Reserve wants to see), while the total unemployment rate seems to be holding for now.
• Consumers are still spending money on services, traveling, and eating out. Considering services make up over 70% of the U.S. economy, this is definitely a good thing.
  • One caveat to this is that retail stores that have more exposure to lower-income earners have reported slower sales. This is to be expected as the effect of higher inflation hits this group the hardest.
• We still have a very strong dollar, but it is weakening compared to other global currencies since other nations are still increasing their interest rates and we are all but pausing our rate increases here in the U.S.
  • A weakening dollar entices other countries to buy our goods and services, which is good for our U.S.-based companies and our economy.
• 1^st quarter earnings for S&P 500 companies have largely been very good. Profits have held up, most companies have had positive surprises regarding their targets for sales, and most companies also gave an upbeat outlook for the rest of the year.

Right now, there is something for everyone, so it is difficult to point to any one data point and say: this is where the economy is going. This much we do know however, the opinions driving the market are expecting the Federal Reserve to pause rate hikes in their June meeting, and they are also expecting the Federal Reserve to start cutting rates by the fall. Unless the Federal Reserve sees some real problems in the economy, they will not be quick to start cutting rates. The main issues they would be looking for would be an unexpected increase in unemployment or a systemic issue with the banks, and so far, unemployment has been holding fairly steady, and other than a few outliers, the banks seem like they are in good shape.

The Market is Not What It Seems

The S&P 500 (“the market”) started off surprisingly strong this year. Not just because it was up in value, but because the gains were distributed across all the sectors of the market: Industrials, Technology, Communications, Healthcare, etc. Since the regional banking issues started in mid-March, that has no longer been the case. The only sectors that are substantially higher are Technology, Communications, and Consumer Discretionary to a lesser extent. Led by (you guessed it) Nvidia, Microsoft, Amazon, Meta (Facebook), and Google. All the other sectors are down in value for the year.

There are a few reasons for this phenomenon. As fears grew of issues with the banking sector, the odds of a recession went up and sent investors into the arms of safe assets like government bonds, it also increased the chances that the Federal Reserve would cut interest rates later in the year. If interest rates fall, technology companies and growth companies, in general, will benefit the most. Secondly, Technology, Communications, and Discretionary were among the poorest performers in 2022, so there was also a rebound effect from them being so underpriced. Lastly, we have the new fad of the year – Artificial Intelligence (AI). The companies I listed above (Google, Microsoft, Meta, Nvidia, etc.)  are deep in the weeds of AI. This is not to say that AI is a bogus idea, but the hype around it right now has sent the value of most of these companies soaring to unsustainable levels.

The bottom line is that either the rest of the market will have to catch up to the top three sectors, the top three sectors will have to come down to reality, or a combination of the two will have to happen.

Our Expectations

Our opinion is a combination of the two will happen: the high-flying companies that have dominated this year’s headlines will have to come down to Earth somewhat, and the rest of the market will have to catch up. Here’s why:

• As we stated above, unless the Federal Reserve sees cracks in unemployment or the banking sector, they will not be in a hurry to reduce interest rates any time soon. They are too afraid that reducing interest rates too early will stop inflation from slowing down, or worse, bring it back up.
• Major market participants think that the Federal Reserve will start cutting rates later this year, and that is how they have positioned their investments since March (hence the big moves in Technology).
• These two ideas are at odds with one another, and someone will have to give. Ultimately, the power is in the Federal Reserve’s hands, and they have the final say.
• To that end, money will have to flow out of the top three sectors and flow into sectors that have been lagging behind all year: Healthcare, Industrials, Energy, etc.
• We believe that major investors will come to the realization that the Federal Reserve may not start aggressively cutting rates this fall sometime over the summer. This will bring volatility in the S&P 500 over the summer while investors rotate to new positions – it’s almost like playing musical chairs with stocks.

How We Are Positioned

Currently, we are defensively positioned. Our latest rebalance, earlier in the month, brought us to a 15% underweight in stocks, compared to our norm. Within stocks, we are overweight in Industrials and Healthcare. We believe that as investors rotate from Technology and Communications to Industrials and Healthcare, it will provide us with a great opportunity to buy undervalued companies at a good price.

Thank you for hanging in there and reading this rather lengthy note, but there is a lot of information that we think can help you in understanding the current environment and what may be expected next.

As always, we thank you for your trust. Please know that you are always in our thoughts, and we wish you a wonderful Memorial Day weekend.

The Paragon Team.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that the strategies promoted will be successful.