Market and Economic Update

Switzerland has been known for its high-end watches and high-end banking, contributing to its reputation for quality, reliability, and security. Last Sunday, one of Switzerland's largest banks, Credit Suisse, was forced by the Swiss banking regulators to be taken over by Swiss bank UBS. It is believed that had the banks not merged, Credit Suisse would have failed. This follows several U.S. regional bank failures and fears that more will come. 

It is reported that billionaire investor and owner of the Carolina Panthers, David Tepper lost $17B in contingent convertible bonds as the Swiss government wiped out Credit Suisse stock owners and bondholders.

Monday – The average national retail gas price is $3.53, down 18.46% year over year. Falling gasoline prices and demand can indicate a slowing economy unless the decline is due to increasing supply which has not occurred.

• Portfolio Change – Underweight the Energy Sector.

Tuesday – In February, U.S. existing home sales increased by 14.5% to a seasonally adjusted annual rate of 4.58 million; however, they are down 22.64% compared to the previous year. This data is not as indicative of the economy's direction as usual. Most homeowners with mortgages have interest rates below 4%, and if they were to sell their current homes and obtain a mortgage for a new property, they would face higher interest rates. This factor discourages homeowners from selling, lowering the inventory of available existing homes on the market. Consequently, home builders may benefit, as a more significant percentage of home sales will likely consist of newly constructed properties.

• Portfolio Change – Allocation to the Homebuilders sub-sector.

Wednesday – The Federal Reserve's Federal Open Market Committee (FOMC) increased its rate by 0.25%, as anticipated, and maintained its 2023 rate outlook at 5.1%, implying another rate hike is expected. The written statement noted, "some additional policy firming may be appropriate," while removing the phrase, "ongoing increases in the target range will be appropriate." During the press conference, when asked about a potential rate cut in 2023, Chairman Powell responded, "rate cuts are not in our base case." Nonetheless, the bond market remains unconvinced. The Fed Funds Futures market is factoring in four quarter-point rate cuts in 2023 and an additional four in 2024. If the Fed reduces rates as aggressively as the bond market suggests, it could indicate a recession in the latter half of 2023.

• Portfolio Change – Reduced fixed income duration with an allocation to T-Bills. 

Thursday - Initial claims for unemployment insurance dropped by 1,000 from the previous week, reaching 191,000, which further supports the notion that the labor market continues to be tight. The Federal Reserve perceives a tight labor market as contributing to inflation since employees can request higher wages. These increased wages are then passed on to consumers through higher prices for goods and services.

Friday - St. Louis Federal Reserve President James Bullard increased his terminal Fed Funds rate target to 5.625%. He believes that banking system stresses will diminish in the coming weeks and months, and the robust economy may cause the Fed to need to raise interest rates further.

There is much uncertainty regarding the future path of markets and the economy. I will continue to monitor the market and economic data and adjust portfolio models accordingly.

Economic and Market Update

The S&P 500 bounced off its 200-day Simple Moving Average, ending the week up 1.9%, fueled by positive economic data indicating continued economic growth, although at a slower pace. Federal Reserve Bank of Atlanta President Raphael Bostic's recent comments to reporters also contributed to the market's upward trend. Bostic supports a cautious approach to monetary policy, stating that "slow and steady" would be the most appropriate course of action. Bostic's comments follow other Fed Presidents who suggested that a return to 0.50% rate increases could be appropriate if future inflation data is hotter than expected.

Below are some highlights from this week's economic data.

Monday:

US Durable Goods orders showed a 4.5% decline in orders for manufactured goods, but if we exclude transportation, durable goods orders grew by 0.69%. Passenger airplanes are big ticket items illustrating how much Boeing contributes to US manufacturing.

Tuesday:

Case-Shiller Composite 20-City Composite Home Price Index showed that year over year, home prices grew by 4.67% compared to 18.51% a year ago. The long-term average is 5.32%.

Wednesday:

Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index was 47.7 compared to 47.4 a month ago, showing an overall contraction in the manufacturing sector for the fourth consecutive month. A number above 50 indicates growth, and below 50 indicates contraction.

Thursday:

Initial Claims for Unemployment Insurance were 190K lower than the 192K from the week before. Though lay-off announcements are increasing, it would seem those losing their jobs are quickly finding new jobs. Next Friday, we'll get a new Jobs Report from the Bureau of Labor Statistics (BLS). Last month showed a surprising monthly gain of 517K jobs and an unemployment rate of 3.4%. This was lower than expected and considerably lower than the longer-term average unemployment rate of 5.9%. The Federal Reserve views the tight labor market as inflationary. Another big jobs number would suggest that there is little slack in the job market and the Fed has much more work to do.

Friday:

The Institute for Supply Management (ISM) Services Purchasing Managers Index dipped to 55.1 from 55.2 the month before, showing expansion in the economy's service sector. A number above 50 indicates growth, and below 50 indicates contraction.

 

Summary:

There is a disagreement between the stock and bond markets regarding what comes next for the markets and economy. Stock market participants see evidence of a strong economy and job market and see equity prices going higher. The S&P 500 trades at 18 times 2023 expected earnings; the historical average is 16. Fourth-quarter earnings were better than feared, but many companies lowered their 2023 guidance suggesting that earnings estimates may come down, making the S&P 500 more expensive at current levels.

 

Interest rate traders are pricing in at least three more Fed rate hikes, and the Fed Funds rate staying above 5.25% through January 2024. The impact of earlier rate hikes are only now being felt in the economy. I struggle to believe we will see significant economic expansion while the Federal Reserve is raising interest rates to slow the economy.

The Federal Reserve Bank of New York increased the odds of a recession in the next 12 months to 57.13% from 47.31% last month.

 

The spread between the yield on the ten and two-year Treasury bonds, a reliable recession indicator, is more inverted than it's been in forty years.

Portfolio models remain defensively positioned. I am not anticipating a deep or pronged recession but rather the Fed winning the battle against inflation by contracting the economy. The S&P 500 is 15% below its all-time high and 13% above last October's lows, and I expect the S&P 500 to remain in this range. If the data changes, we'll adjust.

Economic and Market Update

This week, the S&P 500 fell 3% in response to data that showed the economy is resilient, but inflation remains stubbornly high. Although a strong economy is usually celebrated, this combination of factors will likely prompt the Federal Reserve to raise interest rates higher than previously anticipated. 

Tuesday - Monthly Existing Home Sales report from the National Association of Realtors, showing existing home sales have declined for twelve consecutive months.

Take Away - Most existing homeowners who have mortgages have interest rates under 4%. To sell their existing home and buy another would require them to buy a home that may cost more than their current home and finance it at a higher rate.

Tuesday – The weekly gasoline report from the Energy Information Administration report showed prices ticked down slightly this week but above the longer-term average.

Take Away – Growing economies require more energy. When the US economy reopened after the pandemic, we saw a spike in gas prices as demand grew faster than supply. A sudden spike or drop in gasoline prices could indicate changes in economic activity.

Thursday – According to Freddie Mac, the 30-year mortgage rates increased to 6.5% this week after falling earlier in the year.

Take Away – The Fed is trying to reduce inflation by slowing demand. Housing is a significant contributor to inflation, and the Fed is raising the cost of money to slow the demand for housing. I expect mortgage rates to follow as the Fed Funds rate rises.

Thursday – Weekly Initial Claims for Unemployment Insurance were 192K, lower than the previous week.

Take Away – There have been lay-off announcements, but they have not translated into claims for unemployment insurance. This could be due to generous severance packages or those being laid off from one company are quickly finding new employment. The Fed is trying to reduce inflation by slowing demand, including labor demand. Data that suggests that inflation remains high and the labor market tight will lead to the Fed further tightening monetary policy.

Friday - New Home Sales were up 7.2% in January month over month but still down 19.4% year over year.

Take Away – In the years leading up to 2007, homebuilders overbuilt. During the Great Financial Crisis, many homebuilders were left with homes they couldn't sell. Since the Great Financial Crisis, new home construction has lagged demand as homebuilders have been reluctant, fearing a repeat of earlier mistakes.

Friday – One of the Fed's preferred measures of inflation is PCE (Personal Consumption Expenditures). Core PCE excludes food and energy, not that food and energy aren't important; it's that food and energy are more volatile, and excluding them gives a clearer picture. The January report showed that inflation moved higher month over month.

Take Away – Reviewing statements made during the press conference following the last Fed meeting; I don't think higher inflation is what Chairman Powell expected. If the data we get between now and the next Fed meeting in March shows inflation continues to increase, we could see the Fed become more aggressive in its approach.

 

I believe we are in or on the cusp of a recession. An inversion of the yield curve between the yield on the ten-year Treasury Bond and the two-year Treasury Bond has often preceded recessions, and this part of the bond yield curve is the most inverted since 1981.

Interest rate traders have been increasing expectations for how high the Fed Funds rate will go. Currently, traders are pricing a 0.25% rate increase at the following three Fed meetings and remaining above 5.25% for the remainder of the year.

Market and Economic Update

This week's Market and Economic Update reviews several key indicators, including the Consumer Price Index (CPI), Retail Sales, Producer Price Index (PPI), Employment, and the economic health of the Consumer.

 

Recession Warning

I’ve warned that some of the economic indicators suggest a recession may be coming. Here I review some of the data I’m watching. 

Market and Econonmic Update

 The Market Rally

Equity markets have begun the year on an uptrend, driven by various factors, including lower inflation data and growing expectations that the Federal Reserve may end its interest rate hikes soon. Some speculate that the Fed may even lower rates later in the year. The S&P 500 finished the week at 4070, surpassing key technical indicators such as the 50-day, 100-day, and 200-day simple moving averages and breaking a long-standing trendline. This is considered to be a bullish signal, indicating that the market could continue to rise in the near term. It's worth noting that the S&P 500 recently reached this level on November 30th and September 12th, indicating that there may also be resistance at this price point.

S&P 500 Fair Value

One method to determine a fair value for the S&P 500 is to use a multiple of earnings estimate. This involves taking earnings estimates for the companies in the index and applying a multiple, such as a price-to-earnings ratio (P/E ratio), that reflects the price investors are willing to pay for expected earnings. This method can give an idea of where the index should be trading based on the anticipated earnings of its component companies.

The Rule of 20 is a method for arriving at a fair P/E multiple, which is used to estimate the intrinsic value of a stock or index. The Rule of 20 states that the fair P/E ratio is equal to 20 minus the inflation rate. The idea is that when inflation is high, investors will pay less for future earnings, and when inflation is low, investors will pay more for future earnings. This Rule is based on the assumption that a P/E ratio of 20 is fair when inflation is zero and that the fair P/E ratio should be adjusted based on the current inflation rate.

Earnings estimates for 2023 have been revised downward over the past year, with initial projections starting at $252. The current 2023 S&P 500 earnings estimate, according to S&P Dow Jones Indices, is $223. The P/E ratio, calculated using today's closing level of the S&P 500, is 18. 4070 would be fair value for the S&P 500 if the inflation rate fell to 2% and the current earnings estimates for 2023 are not revised downward any further.

Let's wait until next week

I want to be completely transparent. Our portfolio models remain defensively positioned and have underperformed their benchmarks in January. We are in earnings season, when companies announce their earnings for the previous quarter and give guidance for the following year. About a fifth of the S&P 500 have reported their earnings so far, and they have been okay but not impressive. Next week we will hear from some of the largest companies in the S&P 500 and the Technology sector, which has been the main driving force behind the recent market rally. Wednesday, the Federal Reserve will conclude its two-day meeting with a rate decision and a press conference, and on Friday, the monthly jobs report will be released. The market rally seems premature ahead of so many unknowns.

Outside the U.S.

The ongoing war in Ukraine continues to be a significant geopolitical risk. On February 5th, Europe will impose additional restrictions on Russian petroleum distillates, which could lead to increased price pressures on diesel and gasoline. While China's reopening is expected to be positive for the global economy, the increased economic activity will also lead to a rise in energy demand, further adding to the price pressure on oil. As a result, I anticipate that U.S. gasoline prices may rise in the coming weeks and months, contributing to inflation and inflation expectations.

Recession Risks

The 10-Year to 3-Month Treasury Yield Spread, a reliable recession indicator, remains inverted by -1.22%. The consumer remains resilient though we are beginning to see a slide in consumer spending. As long as the unemployment rate remains below the Feds' projected 4.5%, I would expect any recession to be mild unless you're one of the 4.5%. The Fed Funds Futures market implies the Fed will cut interest rates later this year, which would also suggest anticipation of a weakening economy and rising unemployment.

Market and Economic Update

The Rhino Report - November 17, 202

The econonmic data can tell us a story if we'll read it objectively. Let's review some of the current econonmic data and see what conclusions we can draw.

 

The JOLTS Report and the Fed

Today’s JOLTS Report showed an increase in the number of job openings. A tight labor market is a headwind for inflation and may mean that the Fed has more work to do, and rates may be higher for longer. Please watch the video for details.

 

The Rhino Report

Earnings season kicked off in earnest this week, and some common themes are developing. Most of the banks who have reported had solid earnings but are increasing their loan loss reserves in anticipation of a weakening economy, factoring in the possibility of an impending recession and an increase in loan defaults.

•  Bank of America CEO Brian Moynihan said, "Our U.S. consumer clients remained resilient with strong, although slower growing, spending levels and still maintained elevated deposit amounts."
• JPMorgan CEO Jamie Dimon said, "There are significant headwinds immediately in front of us – stubbornly high inflation leading to higher global interest rates, the uncertain impacts of quantitative tightening, the war in Ukraine, which is increasing all geopolitical risks, and the fragile state of oil supply and prices."
• Goldman Sachs also beat estimates. Goldman issues a credit card in partnership with Apple. In an interview on CNBC, Goldman Sachs CEO David Solomon explained that they see consumers paying off their balances more frequently than expected.
•  Some retailers have reported excess inventories and will need to reduce prices to sell their overstock. Sales could be plentiful and create early bargains for holiday shoppers.
• Delta, United, and American Airlines reported high demand with no sign of a slowdown. Some historical travel patterns are changing as remote workers live in one location and commute to be on-site a couple of days a week. Some people are combining leisure travel with remote work.
• Shipping container costs have dropped 70%, and railroads, trucking companies, and package delivery services have reported a falloff in freight traffic.

My takeaway is that there is evidence that some areas of the economy are slowing. But, with the unemployment rate at 3.5%, the consumer is employed, has money, and remains resilient. People are managing inflation by buying fewer goods while spending more on services and experiences. Almost 150 S&P 500 companies report earnings next week, which should give us further insight into the state of the consumer and economy.

Equity markets rallied Friday based on two pieces of news. An article in the Wall Street Journal (link) suggested that future Fed rate hikes may be smaller after the 0.75% expected in November. This view was reinforced by comments from San Francisco Fed President Mary Daly, who said the Fed should avoid putting the economy into an "unforced downturn" by raising interest rates too sharply, and it's time to start talking about slowing the pace of the hikes in borrowing costs (link). At some point, Fed rate hikes will slow and then stop, at which time markets can stage a sustainable rally. Until then, all rallies are suspect.

 Thursday, we'll get third-quarter GDP. The Federal Reserve Bank of Atlanta's GDPNow estimate for third-quarter GDP is 2.9% (link). As a reminder, first-quarter GDP was negative 1.6%, and second-quarter GDP was negative 0.6%. If third-quarter GDP comes in positive, it would be a short-term trend and suggest the economy is expanding following a brief, shallow contraction.

Friday, we'll get the PCE (Personal Consumption Expenditures) report, a measure of inflation favored by the Fed. The Federal Reserve Bank of Cleveland Inflation NowCast shows PCE (Personal Consumption Expenditures) and CPI (Consumer Price Index) growing by 0.8% month over month (link).

We'll learn a lot about the economy in the coming week. I'll be paying close attention to what companies have to say about their earnings, particularly regarding estimates for the future. If GDP shows growth without clear evidence that inflation is abating. I don't see how the Fed can become meaningfully less aggressive without further bringing their credibility into question. 

The Bear View –The Fed does not have a good record of being able to raise interest rates without causing a recession. If we are in or on the cusp of a recession, it would be unusual for markets to have bottomed. Markets don't usually bottom before a recession has even been declared. Typically, markets do not find a bottom until the Fed has stopped raising interest rates. It's difficult for market participants to assign a value to a company's stock until there is clarity about how high interest rates might go and the impact on earnings. Earnings estimates have come down but may need to come down further. We could see the S&P 500 settle in the 3200 to 3400 range depending on earnings and the market multiple applied.

The Bull View - There is no guarantee that anything that has happened in the past will ever occur in the future. The economy shows signs of weakness in some areas and strength in others, and it is hard for the economy to contract significantly with low unemployment. The fourth quarter is a seasonally strong period for equity markets, and there is historical precedence for markets to rally following mid-term elections. The S&P 500 could move higher before meeting technical resistance at the 100-day simple moving average (3918) and then the 200-day simple moving average (4134). Above this level, I think we would need a fundamental catalyst.

A simplified explanation of a typical cycle is as follows:

1.)   Inflation rises due to an overheated economy

2.)   The Fed raises interest rates to fight inflation

3.)   Higher rates make borrowing more expensive, reducing demand

4.)   The economy begins to slow

5.)   Higher rates and reduced economic activity put pressure on corporate earnings

6.)   Lower corporate earnings equate to lower stock prices

7.)   The economy begins to contract, and inflation moves lower

8.)   The Fed eases monetary conditions to stimulate the economy

Nothing about anything that has happened in recent years has been typical. The Fed was easing monetary policy in response to the Pandemic, not an overheated economy, and probably remained accommodative longer than needed resulting in higher inflation. Market highs were driven by unusually easy Fed policy, so when the Fed began to tighten and raise interest rates, the market anticipated the process, jumped ahead, and moved lower. We have to let the cycle run its course and allow the market and the economy to find equilibrium based on economic fundamentals.