The second quarter showed no let up in the mixed directions of the equity market. The net result was the best quarter since 2022. The Oak Springs portfolio enjoyed the performance of our stock positions but was slowed by the fixed income and commodity side of our diversified portfolio. Both of those investments were hurt by the rising strength of the US dollar and the fear of inflation brought on by the rising cost of oil.
The Magnificent 7 stocks, which powered the stock market for the past three years, continued to lag through the second quarter. The Mag 7 leadership was occasionally replaced by the chip makers and sometimes by value stocks. A real mixed bag. The stock market runs on earnings, and that is where the Mag 7 companies retain their leadership. Ten stocks are producing over half of the earnings generated by the 500 stocks in the S&P.
The US dollar has been painful for all other world currencies. The dollar has gained strength as the global economy continues to weaken. The world economy runs on the ability to trade goods using the dollar as the purchasing currency. As the dollar strengthens, the cost of goods increases for every country but the US. Goods sold into the US are cheaper, meaning importing deflation. But US goods sold to other countries became more expensive.
A strong US dollar might sound like a good thing, but it creates real issues for other countries and blowback for the US. Countries such as Japan fight to protect the value of their currency against the dollar by selling dollars from their reserve account created by global trading. As that trading subsides, they have fewer dollars in the reserve account. Then they begin selling their gold and silver holdings along with their US treasuries/bonds. That drives down the value of gold, silver and treasuries. An additional response was the interest rate hike initiated by the European Central Bank.
The war in Iran has been shrugged off by the US stock market. The point of concern is the rising price of oil and the possibility the Federal Reserve will hike interest rates to ward off inflation. The prediction markets forecasted three FED rate hikes before the end of the year. However, the most recent readings showed inflation is not a problem. Although there was an initial inflation bump with the oil price shock, that inflation has not spread throughout the economy. The inflation read for June showed inflation was slowing and the firm Inflation Now has inflation as low as 2.6%. That sounds like good news, but maybe not. The oil price shock created demand destruction for other goods and services and showed a real weakness in the purchasing power of consumers. A FED rate hike would be just the thing to bring on a recession.
The first quarter GDP number was 2.1%. Approximately 70% of that number was generated by spending on AI infrastructure buildout. Consumer spending normally accounts for half of the GDP but in the first quarter only added about .3% to the total 2.1%. Very weak consumer spending.
The spending by the hyperscalers on the AI infrastructure buildout has become the US economy. Over 60% of commercial building is data center related construction. Amazon, Google, Meta and Microsoft are spending $1.6 billion every day on infrastructure. That is a reason the Magnificent 7 has become the lag seven. The original spending came from the cash reserve stockpiles previously used for stock buybacks. That money was spent and the companies are now using cash flow, stock sales and bond issuances. There is a growing concern that the cost of the buildout and the debt repayment schedule will outstrip the ability to create cash. No one is doubting the future of AI. But no one doubted the future of the internet before the 2000 bubble burst.
Without the spending on AI buildout the slowing of the US economy would be very evident. The June employment number showed 57,000 nonfarm payroll jobs added. Expect that number to be revised down. The unemployment rate dropped from 4.3% to 4.2% because over a million people had simply given up on finding a job and were thus “removed” from the labor force. Economists are describing the labor market as “slow hire, slow fire.” Not good if you are looking for a job. Healthcare, education and construction are the stronger sectors, reflecting government spending and the AI buildout. Leisure and hospitality, retail, manufacturing, professional and business services are the weak sectors reflecting a weaker consumer.
We are in a midterm election cycle. That typically creates summer and fall messiness in the stock market. The Federal Reserve has a new chairman with new thoughts. He has promised to provide less insight into what the FED might do, causing the markets to focus on what can be seen rather than what the FED might do. Don’t expect rate hikes. The FED’s next action will probably be a rate cut. Weakness in the private equity arena may spill over into the public markets. Failures in the private equity investments would hit insurance companies and pension funds very hard. Both have invested heavily in the private equity space in a reach for higher returns
As we work our way through the 3rd quarter I am adding to the value and DOW stock positions. I removed our silver position. Silver and gold will move up and down while facing pressure from the strong dollar. You will also notice our cash position is building. I see the next real buying opportunity developing as we move into the fourth quarter. Our portfolio will remain diversified in the face of market uncertainty.
