Market Jumps on Jobs
What happened last week?
- The S&P 500 gained 1.83%
- The Dow Jones added 2.02%
- The Nasdaq composite rose by 2.04%
Last week’s equity advance suggests investors think employment can continue to hold up in the face of 500 basis points of Fed tightening. Meanwhile, profits have waned and the economy has softened.
Following the resolution of the debt ceiling negotiations, we see a spate of heavy Treasury bill issuance.
3 Things to Know
An employment slowdown
Persistent demand for services and labor hoarding is keeping employment growth stronger while recessions are unfolding in manufacturing, trade and residential construction.
In May, employment gains were nearly twice as large as forecasters anticipated. Construction, trade and retailing — industries that are weakening — all saw gains in employment, while manufacturing employment fell only slightly.
Amid negative investor sentiment and bearish positioning in equity markets, equities have rallied on the expectation that labor market gains can “outlast” the Fed’s tightening impacts on the broader economy.
In a rolling recession scenario, the economy may escape a broad-based plunge. Nonetheless, we are skeptical that recessionary industries under considerable profit pressure will be able to maintain their hiring pace.
With falling inventories and reduced demand, we believe a net slowdown in employment remains ahead. Booming industries, such as travel and leisure, will eventually slow, too.
More tightening ahead as the Treasury drains liquidity
Following last week’s passage of the US debt ceiling suspension, the Treasury will sharply increase net issuance to rebuild its depleted cash balance. This will mean a net increase in US Treasury bill issuance of perhaps $400 billion in the near term, with larger borrowings of longer-dated Treasuries at auction in the months beyond.
As of Friday, the Treasury had announced $223 billion in gross new issues of less than three months in maturity.
Such a heavy supply of “risk free” high yielding Treasuries is competition for investor assets of every sort. With six-month bills yielding near 5.5%, the bulk of the early borrowing will be concentrated in the highest yielding, least risky Treasuries.
This is more likely than not to effectively tighten financial conditions in the period just ahead.
Capturing improving value outside of mega-caps
While the value proposition in small-cap shares is apparent, moving down in capitalization doesn’t come without taking on some additional risk.
When the Global Investment Committee (GIC) moved small and midcap to overweight in April 2020, economic and pandemic-related conditions were still highly uncertain, but policy was unambiguously supportive.
We don’t enjoy those same tailwinds today. The longer interest rates stay high, the greater refinancing risk will be for small, more highly levered companies.
CGWI’s preferred way to leg back into the SMID space is through an up-in-quality approach.
Profitable small and midsized stocks are more likely to survive a period where capital costs remain elevated than those that rely on access to debt or equity markets to sustain growth.
See our weekly CIO Strategy Bulletin for more details