August is clearly a difficult month, true to form for 2023. As many often look for a reason, I thought that I would take some time and go over those points that I felt seemed to be most important. The first is the inflation measures from last week; CPI (Consumer Price Index) and PPI (Producer Price Index). Both indicators came in extremely close to expectations and continue to show a moderation in inflation. In order to see what the institutional money thinks in this regard, we look to see how the institutional probabilities for future rate hikes change after the indicators are announced. I look at this as often the media will tend to pander to their constituency and interview analysts or authorities that are aligned with their thoughts. By looking at institutional probabilities, it is a reflection of what the progression of rates is expected to be. At present, the odds set in the Fed Funds Futures markets show a very low probability of a September increase in the Fed Funds Rate. Presently it sits (as of this writing) at 16%, so clearly a low probability. Since the next rate meeting won't be until Sept. 20th, this provides plenty of time for more info to be presented.
The market is not giving up on a hike later in November, but we have a lot of time for the data to come in. It should be remembered that the closer we get to the Presidential Primaries and ultimately the election, the less chance of voter swaying decisions could be made. For the markets, I don't see any motivation for major trend changes. Momentum is trending higher and likely to stay that way. There's still some disbelief about a rally, which means it could keep going. Earnings came in very well for the second quarter, without any huge warnings about profit deterioration for the third quarter.
One of our favorite market commentators, Thomas Lee, proprietor of FundStrat, actually feels that we are now closer to a situation where the measures of inflation are subsiding to such an extent that the Fed could cut rates in early 2024. This could actually be the roadmap for the perfect storm. If we have a Fed that has now orchestrated an interest rate tightening cycle so aggressive that it stops rising inflation in its tracks but doesn't do so at such a robust rate that the economy is kept from diving into recession, it could be a perfect runway for continued equity market expansion due to the avoidance of the much-feared recession. See below Mr. Lee's chart and numbers of his expectations on the CPI currently and his projected:
He goes on to show how the Fed in 2000 and 2006 hit the rates too hard and this threw the economy into a recession. If Powell continues his rate hikes the same could be expected, but if not, the growth engine could stay in gear and keep the markets from hitting the ground. He does this by measuring the "Real Rate." This is the difference between Fed Funds and the CPI. When this number becomes too high, it tends to signify that rates have hit a high point and are due to come back down:
There is another point that I feel Powell is paying attention to that others have not, and one he has made no mention of. This is the extreme economic weakness being seen in the real estate and general economic situation in China. The Chinese economy is mired in a rut, bad enough that the government will no longer report youth unemployment which is thought to be about 21%. If one is to look at the global economy, China is the engine of production for the biggest engine of the world for consumption, the US. If China continues to show signs of economic slowdown, it would stand to reason that this is primarily due to US consumption slowing. In Barron's this past Sunday, there was an article titled, "China Slips Into Deflation. Beijing Is Losing Control." In the article, it is said, "Demand for China's exports fell 14.5% in July compared with a year earlier. And, most of all, households and private businesses seem to have lost confidence in the direction of central government policies and the government's ability to guide the economy amid mounting domestic and external challenges." It goes on to say, "These problems are compounded by unfavorable demographics, with fertility rates falling and population aging rapidly; a creaking financial system; and dismal productivity growth." They finish with, "China is now too large an economy to export its way out of a downturn, particularly when the world economy is sputtering." This follows the cover article from the Wall Street Journal from last Thursday titled, "China's Deflation Deepens Global Risks." In the same issue of the Journal, lower on the front page, there was an article titled, "Germany's Tardy Trains Derail National Psyche." It is clear that the growth engine of Europe is also showing major signs of stress which isn't a good sign for overall global dependence on the US's consumption.
Why do I partially think that a recession is not in the cards? There are really two things that I feel are important. First is the true importance of AI. AI can be used in so many different places that it acts in a very deflationary manner which increases profitability without the need for greater production, and increased margins due to greater efficiencies in virtually all industries. It is true that AI has really been in practice for the better part of the last five years, but it has just been this year that it has been really bantered about in the media and the layman has been able to really grasp what it can entail. The other reason why I feel that recession is not in the cards is my favorite point to harp on, the massive amount of liquidity that is still floating around out there. Thomas Lee gives an updated chart of the magnitude of this number as of the 9th of August. With this much cash available for all sorts of purposes, even with interest rates spiking to the extent they have, there are still massive amounts of cash out there to digest these highly elevated interest expenses. See below:
The stock markets of the world are the ultimate reflection of the shock of higher interest rates, and as of now, the developed international markets have hardly even flinched, and the emerging markets (ex-China) have only experienced small declines. In the US, August has ended a five-month winning streak. There have been 37 prior five-month winning streaks since 1928, and 29 of them extended to a sixth month. In the four prior streaks where the fifth positive month was July, the S&P 500 was higher through year-end all four times.
Meanwhile, the Citi Economic Surprise Index for the USA is the highest since March 2021. And yet, demand for commercial and industrial loans has tanked, which has been a pretty reliable recession indicator in the past. Again, an additional reason why when there is so much cash on the sidelines is that there is almost infinite amounts of liquidity to absorb this economic shock.
In closing, there was another article in this past weekend's Barron's worth mentioning. It was titled, "Bubbles and Bailouts: The Fed and Long-Term Capital." In the article they mention Black Monday in 1987, the collapse of Long-Term Capital in 1998, the Dot-Com bubble of 2000, the Great Financial Crisis of 2007, and the mini-banking crisis of 2023. In all cases, they speak to the power of the Federal Reserve to inflate their way out of massive financial devastation. Will this time be any different? It is still too soon to tell, but in looking at the action out of Gold and the US Dollar, credit should still be given to Fed Chair Powell. He has been quite masterful at saying, "Hey, this is what we are going to do." He did so months before actually taking action and in doing so this has given the financial markets time to react and prepare. The jury is still out this time as we are not quite sure he is done tightening, but at present, he seems to be fulfilling his desired objective of slowing and reversing the course of inflation and not doing so to an extent that it totally extinguishes the growth of the US economy.
Get Ken's Weekly Market Commentary Delivered In Your Inbox!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
Investing involves risks including possible loss of principal.
The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.