I have been able to understand how negative the equity markets of the world can be by listening to CNBC in the mornings, at about 5:15 west coast time. When the commentators are interviewing random politicians or business owners about mundane subjects it is clear that there is not a tremendous amount of substance, to pay attention to. We are in such a time. We have been in a somewhat flat spot as we are now digesting fourth-quarter earnings from 2022 and measures of inflation and the future actions of the Fed in their seemingly endless pursuit of squelching inflation. There doesn't seem to be much on the news about COVID any longer, and strangely enough, not a lot about the Russia-Ukraine conflict either.
The current issue is that of the debt ceiling and the possible bankruptcy of the US Government because of needing to raise the ceiling. On Sunday Speaker Kevin McCarthy announced that he and President Biden will meet at the White House on Wednesday to start talks on the debt ceiling. This is more of a political hot potato instead of an economic one as this discussion could have an impact on the beginning course of the presidential election positioning for 2024. McCarthy (republican) made an unequivocal statement that Republicans will not cut Social Security or Medicare. Republicans were facing big headwinds from their constituents as Democrats hammered home the point that Republicans were prepared to cut these two popular programs to meet their spending cut demands. McCarthy knows he has a razor-thin majority and cutting these popular programs is a strategy for Democratic victory in 2024. Another point McCarthy is dealing with is his comment about cutting defense spending. In looking at the US Dollar and interest rates, it seems pretty clear that the media is more twisted up about the debt debate than the financial markets. Stay tuned!
What I would like to touch on is what is happening in the markets (both equities and bonds) that seem to be driving the markets currently. The US Dollar has been progressively weaker since late October last year, and this supports an impending ending to the Fed's voracious series of interest rate hikes. I am including below two important graphs. The first is a Dot Plot of the forecasts of Fed interest rate hikes and cuts expected for 2023. The Dot Plot supports the fact that we have gone from experiencing 75 basis point hikes, to 50 basis point hikes, and now we are expecting a possible 1-3 and done, of 25 basis point hikes beginning Wednesday of this week. What seems to support this is the second graph that shows that bonds are very clearly positioned for a reversal in their decline and according to Jeffrey Gundlach of DoubleLine, long-dated US Treasuries are in a position to outperform even equities for 2023 following a dreadful (worst in history) 2022.
If the above chart is true, and interest rates are prepared for a top and eventual decline, then this could very well provide fuel to the fire of the equity markets recovery. Again, looking at the last seven bear markets since the 1987 crash, we have seen the market bounce back an average of 43.6% after dropping 33.1%. See the chart below showing all seven declines and the subsequent recoveries.
The last chart that could reflect what the expectations are for the current market is a comparison of three different scenarios. The first is all year’s average market action since 1950. The second is all of the year's average return after a negative prior year. The third (in the bold blue line) is the average action of the markets in years when the current year has started with being up over 1.4% in the first 5 days, following a negative year. The last little red bold line at the lower left is how this year is starting. Given that 7 out of 7 times the market has been up strong following a negative year and starting over 1.4% in the first 5 days, I find it to be quite significant.
So the question that comes to mind is what is happening with inflation and interest rates are given that it appears that the Fed is coming to an end of this tightening cycle? For that, I have below the picture of the core PCE inflation progression and the 3-month PCE inflation measure. It is clear that this measure of inflation hit a wall and has been dropping like a stone since October. Thomas Lee's Fundstrat measured the 64 components of this PCE measure of inflation and has found that over 54% of these LEADING indicators for inflation are rolling over.
Most inflationistas adopted the 1970-1980 view and argued the global economy was in for a period of extended high inflation. Note that when the headlines in October of last year when these inflation measures had already begun to turn, the price of oil was already down 30% from its highs! According to CITI research, the NASDAQ Composite fell over 36% from high to low in 2022 and finished the year down 33%. The closest comparison to this happened to be during the last inflationary period of 73-74 where these same numbers were 35% and 31%. I don't find this to be a coincidence! The issue that will need to be watched out for is whether the aggressive rate with which the Fed has raised interest rates could create a recession and not a hopeful soft landing. If this is the case, then a tough second half for 2023 could be in the cards. During the 73-74 time period:
- Deficits had built up strongly, helped by the cost of the Vietnam War.
- Unemployment bottomed out at 4.6% in October 1973 and started rising steadily. We just hit a low of 3.5% but see no convincing evidence that we are set to head higher yet.
- The economy grew at a final rate of 3.9% real GDP in Q4, 1973 followed by a -3.4% in Q1 of 1974, and a trough of -4.8% in Q1 of 1975. This was due in no small part to the Fed turning hawkish in March 1974.
The jury is still out on how the actions of the Fed in this cycle will play out in the economy this time. Here are some headlines from the collapse in housing activity in 1973-1974 courtesy of the New York Times on December 31, 1973.
- More houses were built last year than any other year in history
- This boom-to-bust decline threatens a crisis for a nation that needs a minimum of 26 million new houses by the end of 1977
- The decline started this summer when mortgage money became scarce and interest rates soared to as high as 10%. the public, already nervous about Watergate and the stock market, quit buying. House sales plummeted by 50%, and builders immediately began to hold back on future projects.
- But even before these economic blows, the cost of housing was becoming a problem for many families. Dr. Michael Sumichraft, the chief economist for the National Association of Homebuilders, believes higher home costs coupled with high interest "priced 60% of all people out of the housing market."
It is quite amazing the parallels that are existent. The year has started quite well for equity markets both stateside and abroad. I don't expect this to continue advancing in a straight line, but I do expect if history is any accurate indication, that this year could be much better than last. Time will tell but we will be here to pay attention and answer any of your questions should they arise.
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