You Can’t Invest in GDP

Mark Luschini, Chief Investment Strategist

The title is not an answer to a question. That would be silly since no stock, ETF, or mutual fund represents the common share of, or sole holding in, a tradeable security representing U.S. GDP. Instead, it is intended to tease a discussion about why GDP matters for investors.

What is GDP?

Let’s begin by defining what it is. GDP, or Gross Domestic Product, as a statistic issued quarterly in arrears by the Bureau of Economic Analysis, measures the value of the goods and services produced during a period. The report quotes a “real,” or inflation-adjusted figure, and is displayed as an annualized percentage. For instance, the recent release of GDP for the second quarter of this year showed a pace of growth of 2.4% annually. While not the case in this report, quarterly GDP announcements can be skewed by large adjustments associated with trade activity and business inventories. In addition, subsequent revisions to the releases that follow may add or subtract to the initial reports so it’s not a perfect science. Still, it is generally considered an influential signal of overall economic vitality.

With that in mind, second quarter GDP was better than expected and above the prior quarter’s 2.0% annualized pace. This is a testament to the underlying strength of the economy and its resilience in spite of inflationary winds that have yet to fully abate and more than a year of the Federal Reserve’s policy of tightening monetary conditions. Indeed, concerns of a recession lurking in the not-too-distant future have all but dissipated. To be sure, risks to the growth outlook for the second half of this year still exist, largely due to restrictive credit conditions, pressure on consumer spending from depleting excess savings, and a weak global economic backdrop. However, from a domestic point of view, fueled by the robust labor market and improving confidence among consumers and businesses about the near-future outlook, a recession increasingly appears to be more a worry for next year than this one. After all, it is a long way from 2.4% growth to contraction, especially with only five months remaining on the calendar for 2023.

What Does the GDP Report Tell Us?

What can an investor take away from the GDP report? Business capital expenditures jumped to a 7.7% annual rate, the best in over a year. That is a sign of confidence from the business community, which reinforces analysts’ estimates for profit growth to resume later this year and into next. It also suggests industrial, materials, and technology companies are likely beneficiaries of the spend directed toward manufacturing structures and equipment and intellectual property products like tech hardware and software applications.

Personal Consumption Expenditures, a fancy way of saying consumer spending, rose at a 1.6% annual rate, but even as that slowed from the 4.2% pace in the first quarter, it was still indicative of a consumption trend that is positive and that is bolstered by still abundant savings, real wage growth that has turned positive amid slowing inflation, and continued demand for goods and services that has not been relieved even as COVID-induced restrictions have long since faded.

Keep in mind that the same strength in the economy seen in this GDP report could also be the ultimate cause of its undoing. Suppose demand fails to cool sufficiently, prompting inflation to continue to run hotter than the Federal Reserve’s 2% target. In that case, monetary officials will likely raise rates further to thwart its advance and risk a meaningful economic slowdown. Arguably, the hikes undertaken so far, 11 in all totaling 5.25% since March of last year, should already have induced a negative impulse upon the pace of activity. Clearly, if it has, it’s not registering as the effects have yet to take a material toll on growth or the labor market. The good news for equity investors is any concern of a significant downshift in the economy that would warrant a large drawdown in the stock market looks increasingly likely to be deferred beyond this year and even, perhaps, well into next.

Portfolio Structures

Guy LeBas, Chief Fixed Income Strategist

For those concerned with the nuances and short-term movements in the bond markets, it is easy to lose sight of the fact that fixed income investments are generating the most income since about 2007. With that in mind, we have—and will continue to— take the opportunity throughout the year to discuss the longer-term themes of portfolio construction. In the July Investment Perspectives, we outlined a “Core/Satellite” approach to fixed income sector allocation, with the “core” comprised of more stable income generating sectors and the “satellite” of higher risk but higher return potential sectors. For simplicity’s sake, we skipped over the discussion of how that core portion of the portfolio can or should be structured. Broadly speaking, there are three ways to structure a core holding of long-term bonds: bullets, ladders, and (especially relevant for today’s environment) barbells.

Bullet Bond Portfolio

A bullet bond portfolio has concentrated bond maturities in a specific year or a narrow set of years. There are sometimes market-related reasons for maintaining a bullet portfolio, but more commonly, a bullet portfolio is designed to meet a specific cash flow need. For example, parents with children expecting to attend college starting five years from today could build a bullet portfolio of bonds maturing in years five through eight, thereby funding education costs with a high degree of confidence.

Ladder Bond Portfolio

A ladder bond portfolio has regular maturities spread evenly over a range of years. For example, a 1-10 year ladder would have a series of 20 bonds maturing every six months, each bond metaphorically represented by rungs of a ladder. Historically, ladders have been the most common individual bond portfolio structure for households. One reason is that laddered portfolios smooth out changes in income, which can be especially important for those relying on income generation. A ladder initially “locks in” a level of income; then, as each bond in the ladder matures, an investor (usually) purchases a new bond at the longest maturity of the ladder. If interest rates have risen, that means a new bond at a higher yield, particularly if the yield curve is normally shaped with long-term interest rates higher than shortterm ones. Since the adjustments happen gradually—10% each year for a 1-10 year ladder—there are no abrupt increases or decreases in income generation.

Chart 1: US Yield Curve Is Deeply Inverted

Barbell Bond Portfolio

A barbell bond portfolio is one with a concentration in shorter-term maturities, relatively few intermediate-term maturities, and another concentration in longer-term maturities. Metaphorically, the short- and long-term bonds represent the weights on either side of a barbell. Unlike bullets, which are designed around a cash flow need, or ladders, which are designed to promote income stability, barbell portfolios are an active choice to take advantage of interest rate market conditions—conditions, as it turns out, like ones we see today. In mid-2023, the yield curve is deeply inverted, with yields on short-term bonds 1.5% higher than yields on intermediate- to longer-term bonds. That inversion creates an incentive to own more higher yielding short-term bonds (the left side of a barbell) than one would normally have in a ladder. At the same time, it is also important to lock in some longer-term, income-generating assets in case short-term interest rates unexpectedly fall (the right side of a barbell).

Table 1: Deeply Inverted Curve Means Barbell Yields More than Other Portfolio Structures

While we like a “Core/Satellite” approach to sector allocations for fixed income portfolios within the core portion of longer-term income-generating assets, the shape of the yield curve today is especially conducive to a barbell portfolio structure. A barbell generates more income than an evenly spaced ladder and mitigates some of the reinvestment risk of owning solely a portfolio of short-term bonds.

The Season Might Be the Reason

Gregory M. Drahuschak, Market Strategist

Equity markets in July reacted to an easing inflation rate, less concern about Federal Reserve credit policy, and growing sentiment that the U.S. could avoid a recession. This combination was enough to give the S&P 500 its fifth-straight monthly gain that more than doubled the 72-year average result for July. The key question for August is whether the market can cast aside typical seasonal weakness and build on the July rally.

Table 2: 2023 Market Data

Inflation Rates Rise and Fall

After touching nearly 9% a year ago, the inflation rate falling to roughly 3% was a significant component of the elements that sent stocks higher. However, the market’s sensitivity to the inflation rate suggests that even a modest upside surprise in the CPI could rattle the market.

Although the Fed appeared to signal that an end to the rate hike cycle might be not far off and, in fact, may already have been reached, the Fed’s commitment to crushing the inflation rate leaves the chance that more rate hikes are still possible.

Odds of avoiding a recession became a major positive when U.S. Federal Reserve Chair Jerome Powell said the central bank’s staff no longer forecasts a U.S. recession, and “we do have a shot” for inflation to return to target without high levels of job losses.

What to Expect

Corporate earnings also provided support for stocks. As July ended, 80% of S&P 500 firms that had reported calendar second-quarter results topped expectations. The 2024 S&P 500 earnings estimate now suggests that next year’s earnings could be 12.5% higher than expected for 2023. With 17 months to go before all of 2024 earnings will be in, this is an aggressive estimate in our view.

Throughout the market rise from the early March low, the market successfully surpassed technical levels that could have thwarted the rise. However, as the S&P 500 reached its July top and after setting several new 52-week highs, it and some other indices reached significantly overbought conditions. How the market works around this will be a key part of trading this month.

Investors welcomed the market’s performance this year, specifically in July, but enthusiasm might have created another obstacle the market must overcome. Three days after the S&P 500 hit its intraday low for this year at 3808.86, the American Association of Individual Investors (AAII) weekly sentiment survey showed that the percentage of respondents with a bullish market view was only 19.2. To seasoned investors, this low level of optimism was a sign that the market was braced for a rally as sentiment measures at extremes like the 19.2% reading are most useful as contrarian indicators.

On cue, the S&P 500 embarked on the rally that by July 27 sent the S&P 500 to its recent high at 4607.07 as the AAII bullish reading at 51.40% touched its highest level in more than a year, which classically suggested the potential for a pullback. Although it was purely coincidental, the Fitch rating agency’s downgrade of its U.S. debt rating to AA from AAA created an immediate weakness in stocks.

Table 3: S&P 500 Percentage Change

As the accompanying table of S&P 500 results in August and September for the previous 13 years shows, August and September are poor for stocks.

Nonetheless, as long as employment remains solid and despite possible near-term choppiness, we think the market will be higher by New Year 2024.