The economic data has supported the bullish case of a “no landing” scenario. That scenario assumes the economy avoids a recession entirely, allowing earnings to start growing again in the second half of the year. That somewhat optimistic scenario is heavily at odds with a Federal Reserve focused on slowing inflation which is only achieved by reducing economic demand through tighter monetary policy.
While markets are rallying short-term, history suggests that equities will not be able to fend off higher rates indefinitely. Such is particularly the case with the 2-year Treasury rate, which correlates with changes to Fed policy. It also suggests that interest servicing on consumer debt will become more problematic over the next several quarters as individuals run out of savings.
However, here is the question the bulls should be asking:
What would cause the Fed to cut rates?
- If the market advance continues and the economy avoids recession, there is no need for the Fed to reduce rates.
- More importantly, there is also no reason for the Fed to stop reducing liquidity via its balance sheet.
- Also, a soft-landing scenario gives Congress no reason to provide fiscal support providing no boost to the money supply.
However, given the recent spate of economic data from the strong jobs report in January, a 0.5% increase in inflation and a solid retail sales report continue to give the Fed no reason to pause anytime soon. If this environment continues, the Fed will continue reducing its balance sheet and maintain interest rates at the terminal rate of 5-5.25%.
The only reason for rate cuts is a recession or financial event that requires monetary policy to offset rising risks.
For example, that strong employment report in January certainly gives the Fed plenty of reasons to continue tightening monetary policy. If its goal is to reduce inflation by slowing economic demand, job growth must reverse. However, if we look at employment growth, it is indeed slowing. As shown, the 3-month average of employment growth has turned lower. While employment is still gaining, the trend suggests that employment growth will likely turn negative over the next several months.
Retail sales data for January is also showing deterioration. This past week, retail sales showed a 3% monthly increase in January, the most significant jump since March of 2021 when Biden’s stimulus checks hit households. However, this is all on a nominal basis. In other words, even though consumers didn’t have a “stimmy check” to boost spending, they “spent more to buy less” stuff on an inflation-adjusted basis. Over the last 11 months, as the stimulus money ran out, real retail sales have flatlined.
While most of the jobs recovery was hiring back employees that were let go, the surge in stimulus-fueled retail sales will ultimately revert to employment growth. The reason is that people can ultimately only spend what they earn. As shown, the disconnect between retail sales and employment is unsustainable.
While not every rate hike cycle ended in a recession, each did have an impact that eventually led to a rapid unwinding of the previous rate increases.
Notably, most “bear markets” occur AFTER the Fed’s “policy pivot.”
Whatever event occurs from an overtightening of monetary policy, the market will reprice lower as expectations of economic and earnings declines are forecasted. Currently, forward estimates for earnings and profit margins remain elevated despite a 17.5% decline from their previous peaks.
Earnings have declined 17.5% from the May 2022 peak, but analysts remain optimistic about a near-term economic recovery story.
If a recession does occur, those expectations for a rebound in earnings growth will decline. While analysts are hoping for 2023 to end at $199 per share, a recession would suggest an earnings reversion to its long-term growth trend, or lower, of $158.
With 79% of companies reported, S&P500 Q4 GAAP earnings are down 23% year-over-year, the 3rd straight quarter of negative YoY growth and the largest earnings decline since Q2 2020.
Assuming that the market can maintain a valuation multiple of 17x earnings, such would suggest a market priced at roughly 2,670. Or, rather, an approximately 30% decline from current levels. While such a significant correction seems unlikely, given the recent turn in the bullish technical underpinnings, that is just what the math of valuations suggests.
In the near term, the bulls remain in control of the market; as such, we must have exposure to participate. However, we continue to think the bulls ultimately have it wrong. As such, one more market decline will likely occur before this bearish period is resolved. That is just what the historical data tells us. However, as is always the case when managing money, we need to remain focused on what the market is telling us.
US Economy
The U. Michigan sentiment index showed further improvement this month. The “current conditions” component (which tends to be correlated to consumer spending) drove the gains in the headline index, while the expectations indicator edged lower.
- BofA card data signaled robust consumption in January. Where is that recession everyone keeps talking about?
- Consumption is expected to slow in February and March.
- Wells Fargo sees three down quarters this year (including the current quarter), …
Source: Wells Fargo Securities
… with most leading indicators now signaling a recession.
- The January CPI report was roughly in line with expectations, signaling persistent inflationary pressures.
– Headline CPI:
- Housing continues to drive core inflation, …
- … with monthly rent CPI holding near multi-decade highs.
- But leading indicators continue to signal softer housing-related inflation ahead.
- The Treasury curve inversion deepened further.
- US retail sales topped expectations as warm weather boosted spending after weak activity in December. Best retail sales numbers in two years.
- Improvements were broad, with autos and restaurants/bars seeing the biggest gains
- The reopening in China should help.
Source: Pantheon Macroeconomics
- Manufacturers are becoming more optimistic.
- The Atlanta Fed’s GDPNow model estimate for Q1 growth moved higher, …
- Next, we have some updates on the housing market. Mortgage applications and rate locks dropped to multi-year lows last week
- This chart shows new home sales compared to previous housing downturns.
- The median CPI is above 7% for the first time in decades.
- The January report on producer prices topped expectations in both the headline and core PPI. Upstream price pressures persist.
- Given the stubbornly high inflation and the ongoing tightness in the labor markets, some Fed officials have indicated a willingness to consider a 50 bps rate hike.
Source: @Jonnelle, @economics Read full article
- Markets took notice of the PPI beat and hawkish Fed comments, with stocks and bonds selling off.
- Mortgage rates have been grinding higher.
Market Data
- Companies have been less gloomy on earnings calls.
- Stocks typically struggle during the second half of February.
- The US has the most potential downgrades relative to global peers, driven by weakness in consumer products, media/entertainment, and tech.
- Should stock investors be concerned about the Fed draining liquidity from the banking system? Stocks have diverged from Fed reserve balances.
- The S&P 500 risk premium is the lowest since 2007. Very low risk premiums can portend poor returns over the next few years.
- Deteriorating global liquidity conditions will remain a headwind for stocks.
Source: Simon White, Bloomberg Markets Live Blog
- Are stock investors finally taking notice of persistent inflationary pressures, a hawkish Fed, and rising yields?
Quote of the Week
Ben Graham said in his book The Intelligent Investor…
“For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself.”
Picture of the Week
All content is the opinion of Brian J. Decker
