In the last three weeks, I have brought focus to the current state of the equity markets and how inflation is the focus of the Fed. What we are observing and investing in the midst of is a subtle balance that exists between the motivations of the Fed as a result of their rescuing effort on the economy due to the COVID shutdown, while at the same time trying to stretch out its mandate over time to not suck all the oxygen out of the room of corporate profitability. We experienced an unprecedented increase in money supply when the Fed flooded the system with capital while shutting down virtually all businesses and then, in the last year, it has raised interest rates 10 times, consecutively, to thwart the imminent inflation that was sure to occur as a result of massive amount of capital chasing too few goods due to supply chain constraints. When major policy decisions are whipped around like this in such a short time, there are going to be some negative repercussions in some industries and specific companies that are more sensitive to these abrupt and large changes.
The first one was small businesses overall that had to restart themselves from a complete stop. They are now forced to try and find employees to fill the roles they have open. The problem they are facing is they continue to have a hard time doing so since this employee pool continues to be compensated to do virtually nothing by the current administration. Again, an oversimplification to be sure, but a problem for small businesses all the same.
From an industry standpoint, the banking system cracked. Before COVID, people went to using online banking due to ease, but for the majority, they continued to go to the bank as they always had. Even with the growth of technological advancements in the banking system they still did not embrace new technologies until they couldn't do conventional banking due to COVID. Then all were forced to do online banking. Once it was recognized how truly simple this is, there was no reason to go back to the old ways of spending time physically going into a branch to do the banking. At the same time, the banks were recognizing massive amounts of deposits being made into their accounts and were forced to do the best they could at earning an interest rate spread between the paltry amounts paid on checking and savings accounts and the amount they were earning on placing the deposits in acceptable instruments and keeping the profits.
The banks encountered a problem due to two main issues. First, depositors that now felt comfortable moving their deposits electronically from very low-yielding accounts into higher-yielding and safe US Government Treasuries- in large numbers. And second, the internal investment management groups within the banks invested these deposits into too-long maturity instruments which decreased in market value quickly when interest rates spiked. This forced these banks to sell their investments at a loss due to interest rate risk, not due to a poor choice of credit quality. These outflows spiraled higher, and a few banks found themselves virtually upside down due to these losses they were forced to take and hence they were put into receivership by the Fed.
Now we are in a new spot. A spot that is being supported by a new momentum born by consumption due to the excess capital still sloshing around in the system, new and higher interest income from short-term instruments, leaner companies acting more profitably with less, and increased profitability due to the efficiencies and deflation that is being increased due to AI across virtually every industry. As technology is advancing, as it always does, another layer is being peeled off the profitability onion and an immediate supercharging of many businesses is occurring.
I have often quoted Thomas Lee of FundStrat, Victor Cossel of Sea Breeze, and Ari Wald of Oppenheimer as they have been very intuitive in their ability to sort through the noise and point out major new trends and opportunities. I will continue to look for these to bring to your attention as I feel that it is more important to discuss what IS occurring and what IS EXPECTED to happen next rather than to discuss what has happened.
Currently, all focus is on Powell and his Fed Governors and their moves to squash inflation. This is quite alarming to many, so I look for history to tell us how these situations have been dealt with in the past and see if there are similarities to the current environment. It might have surprised many, but Volcker ended the inflation war on Oct 5, 1982 (the first ever utterance of ending the war, which he made in a speech).
Here were the inflation stats from October 1982 (Sept): Headline CPI 3.7% YoY; Core CPI 4.5% YoY
See the point? The Fed can end the inflation war (pivot) when the collective public believes inflation is broken by observing economic indicators that reflect what the effect is. I can't know when this moment will arrive this time. Will it be when shelter/rent prices finally tank in CPI? Maybe. That is my best guess. That will be sometime in 2023. The stock market is beginning to adapt to this view. This, in our view, explains much of the surge in stocks YTD. It also helps that EPS estimates are finally starting to creep higher. 2Q23 EPS is expected to be +0.1% ex-Energy. The regional PMIs and ISM also seem to be bottoming, so this makes sense. EPS growth finally curling up:
- 4Q22 S&P 500 ex-Energy; -7.1%
- 1Q23; -1.7%
- 2Q23; +0.1%
This is the first positive YoY EPS growth (ex-Energy) since 1Q22. And it also shows the low EPS growth rate was 4Q22 -- which is also when the S&P 500 bottomed, in our view. If companies can increase earnings in the face of dramatically higher interest rates, and the measures of inflation are showing that the Fed's work is working, then this pause could be the "flinch" that is needed to show a change in the Fed's actions and supports higher equity prices going forward.
The biggest industry in the US is housing. On Tuesday of this week, we got the housing numbers for May:
Housing Starts, May: +21.7% (largest monthly increase on record); Single-family +18.5%, Multi-family (apartments): +28.1%.
Permits: +5.2%
It must be remembered that the equity market is a discounting mechanism. The stock market topped out before the Fed started raising rates. So, it would be expected that the markets would bottom and begin recovering before the Fed was done raising rates. This appears to be happening now.
As is always the case, a few companies tend to lead the charge off the bottom (I went into detail on this last week) and just when it appears that Jack's new beanstalk has grown to the sky too fast, the recovery begins to broaden into other companies and other industries. This is an argument for market breadth to start expanding.
In our view, the Fed FOMC rate decision and press conference (last Thursday) was essentially a "green light" for financial conditions to ease and for business CEOs to breathe easier -- thus, we see these are conditions to allow a greater number of stocks to outperform, beyond FAANG (the first group to bounce off the bottom).
Besides prices of sectors and companies recovering higher, what it is that HAS TO HAPPEN is earnings reports and forecasts need to reverse and begin moving higher. And this recovery in stocks is supported by the recovery in earnings growth. As this latest report from Thomson Financial Refinitiv shows, EPS growth ex-Energy is expected to rise in 2Q23.
- this is the first rise since 1Q22
- is the earnings recession over? maybe.
And if one is wondering what differs between a Fed cycle and an inflation war? Below are the highlights:
- the key is the Fed doesn't have to necessarily break anything
- they can stop when inflation breaks
- this threshold is not entirely clear, though
In closing, I am going to share a chart from Thomas Lee of FundStrat that shows exactly what happened when the Fed pivoted during the Volker era. I keep bringing up this period as this was the last time that the Fed really went on a warpath and increased rates consecutively for a long period. I have no idea if we will experience a recovery to new highs on the markets immediately but given that there is so much money sitting on the sidelines parked in short-term instruments, eventually, it should want to be placed in higher long-term opportunities. These opportunities exist in equity markets both here in the US and outside the US. Since money was dropped on other countries' economies as well, they could quite possibly experience the same benefit of the recovery. And as I had mentioned previously, the stock market was way ahead of the Fed and this time should prove to be no different.
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