Saturday, October 22, 2022

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.

Friday, October 7, 2022

JOLTS, Jobs & Inflation

This week’s strong employment data is fueling fears that the tight labor market is contributing to inflation, and the Fed will need to raise interest rates further in response.