Ladies and gentlemen, the weekend! In this space each week, Greg and I share some of our favorite articles, notes, and graphics from the past week along with our commentary. Please feel free to provide feedback and forward along to others if you enjoy. We appreciate you taking the time to read. 

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Professor Siegel's Weekly Commentary

“We are getting a lot of headlines about the debt ceiling. My belief is that we will not get a default. I also do not think June 1st is really a hard deadline. I believe Democrats feel pressured to meet the Republicans in some way. I think if they met them halfway, that is a good political position for the Democrats. If the Republicans get half of what they want, it can be regarded as a victory. What is most likely is another ‘kick the can’ down the road measure to extend the debt issue until right before the presidential election.

Bottom line: Treasury bill yields are elevated. It is not a good sign credit default swaps were showing a higher risk on U.S. government debt than that of Brazil. But we are 99 to 1 odds the U.S. government will not default on its debt.

When you combine a subdued outlook for the economy with falling consumer sentiment, rising jobless claims and fear of recession rising, value stocks suffered relative to growth stocks; the latter are viewed as bastions of stability and less economically sensitive. The dollar has been soft and that helps large cap tech stocks that have disproportionate profits overseas.

Summarizing my views: I remain cautious on the markets. Value stocks are also taking hits from fears of further fallout from the regional banking failures. I think tightening lending restrictions will further crimp the economy. The market is positioning for a mild recession and certainly there is risk it could deteriorate further until the Fed really pivots towards cutting rates.”

Jeremy Siegel is straight to the point in his commentary this week. We are probably working off a false debt ceiling deadline, but everyone would rather solve it sooner than later. The sound bites from negotiators and House Speaker Kevin McCarthy had been positive until they hit pause midday Friday.

The outside chance of a default combined with fair-to-cautionary economic indicators has kept the market rangebound and positioned for a mild recession.

The Patent That Helped Vanguard Clients Pocket Big Gains Expires

“The patent that’s given Vanguard Group an edge over competitors for the past 20 years — and helped its clients pull in more than $100 billion worth of additional investment gains — expired today.

Rival fund managers are now free to replicate a unique but controversial fund structure created by the Jack Bogle-founded firm in 2001 that allows mutual funds to act like exchange-traded funds by generating returns for investors while minimizing taxes…

‘The SEC is the clear lynchpin here,’ said Nate Geraci, president of The ETF Store, an advisory firm. ‘If they green-light this structure, I expect a number of traditional mutual fund companies to seriously explore using it.’

The regulator needs to grant companies exemptive relief from current rules that would let them use the fund structure that effectively gives a mutual fund access to the famous tax efficiency of ETFs.

‘If the SEC doesn’t allow this structure for additional asset management firms, there will be real questions raised as to whether the SEC is perpetuating an unlevel playing field by only allowing the already dominant Vanguard sole use of this expired patent,’ said Geraci.”

A Vanguard (formerly) patented process allowed them to launch exchange-traded funds (ETFs) as a share class of their popular mutual funds, rather than a standalone ETF. That structure was beneficial in a couple of ways.

First, it allowed them to offer ETFs, which have some inherent benefits compared to mutual funds.

Second, the ETFs (as a share class) allowed the mutual funds to be more tax efficient. The ETF share class can trade stocks and bonds capital gains through an in-kind redemption process. That benefit extended to the stocks and bonds held by mutual fund share classes. This hybrid nature provided a tax efficiency advantage. When comparing the Vanguard mutual funds to their competitors, they had less capital gains distributions.

The patent expiration means that mutual fund competitors may likely use the same process if the SEC approves.

The Leading Indicator That’s Pointing Away from a Recession

“Residential investment makes up under 5% of the economy, but it’s been a drag on economic growth for eight straight quarters. Over the four quarters through Q1 2023, real GDP grew about 1.6%. But that’s after accounting for a 0.6-0.7%-point drag from residential investment. That’s a lot!

The cause shouldn’t be a surprise. The Federal Reserve (Fed) began its most aggressive policy tightening cycle in 40+ years as they looked to get on top of inflation. That sent mortgage rates from 3% to 7% in less than a year, freezing the housing market. Affordability collapsed due to higher rates and elevated home prices…

Between 1980 and 2010, we had five recessions, and each one was preceded by a huge decline in single-family housing starts.

Here’s what’s interesting, however. The chart also shows that housing historically bottomed prior to the end of a recession and has typically led the economy out of one. It typically coincided with the Fed reducing interest rates in response to a slowing economy…

And now there’s good news. Starts and permits appear to be turning around. Starts are up 5% since November 2022, while permits have already increased 14% over the three months through April.

Here’s a summary of what’s happening:

• Due to high mortgage rates, most homeowners (who probably bought their homes or refinanced at low rates) are “locked in.”
• So, there’s not much inventory in the existing home sales market.
• However, there’s a lot of pent-up demand due to a record number of people in the 25-34 year age cohort, which is the prime home-buying age.
• These potential homebuyers are being pushed into the new homes market.
• That is very positive for builders and the economy since new home demand matters a lot for economic growth.”

As this quarterly earnings season comes to a close, FactSet notes that 107 companies mentioned “recession” on their earnings call, which is down 3 quarters in a row and from a peak of 238.

Thanks for reading. Have a great weekend!

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