Dear Clients,
Wall Street is liking what it’s seeing from the latest U.S. economic data. The consumer
price index in June rose less than expected, boosting major stock benchmarks
Wednesday. The S&P 500 closed at its highest level since April 2022.
Stocks could continue to gain momentum in the week ahead as traders turn their
attention to earnings results after the past week’s softer inflation news.
The Dow Jones Industrial Average on Friday notched its best week since March after
encouraging consumer and wholesale inflation in June cemented the likelihood that
the Federal Reserve is closer to the end of its rate-hiking campaign. Traders see a
95% certainty the Federal Reserve will tighten again at the central bank’s July meeting
and I don’t believe the latest cooler inflation data was enough to cause the Fed to skip
this meeting. The Dot Plot is 81% sure the Fed will stand pat in September. I am not
sure I agree with that, as I think inflation will have to continue to cool quickly for the
Fed to skip in September.
Both inflation prints — Wednesday’s consumer price index and Thursday’s producer
price index — are the last major economic reports central bank policymakers will
get before their July meeting. In fact, Fed speakers will go dark next week as the Open
Market Committee enters a “blackout period” before they convene for a two-day
meeting starting the following week, on the 25th and ending on the 26th.
Instead, traders will turn their attention to earnings next week. Market participants are
expecting results to turn in a third straight quarter of lower profits, with FactSet data
showing that S&P 500 earnings are forecast to have fallen nearly 9% year over year in
the latest three months. Still, those low expectations could leave room for positive
surprises, as was the case in the last earnings season. Some market participants
expect this period could mark the trough for earnings and urge traders to pay more
attention to forward guidance. I agree with this premise.
As a result, investors might be encouraged because next quarter is expected to be
down 1.7%. The fourth quarter is expected to be up 7.4%. And next year, expected to
be up 12%, according to MSNBC. You know what, maybe we will soon be climbing out
of the depths of this earnings recession.
That would be a positive development for equities, which have already enjoyed a
strong start to the year, and I expect will continue in the second half. A recent
broadening of this year’s rally has added to that optimism.
“It’s not just a relatively small number of mega cap technology companies that are
driving the market higher – we’re seeing much more widening of the rally and a lot
more companies that had struggled throughout the year or have just barely been
positive starting to do well,” BMO Wealth Management’s Chief Investment Officer
Yung-Yu Ma said in a weekly market update. “And that’s a great sign for the market
and market health.”
To be sure, not everyone agrees that this earnings season will be a good one. In a
note this week, MRB Partners warned traders that frothy valuations have “raised the
stakes” for earnings to meet or exceed expectations. In particular, the firm said tech
stocks are “priced for perfection” and should be avoided. I don’t agree with this, as
though I think there will be a “catchup trade” outside the big 7, I do think AI has
changed the earnings for many quarters for the technology big guys. With that said, I
do think this Big Technology rally has come too far, too fast.
The above phenomenon changed somewhat in late June and the first half of July, as
other sectors such as financials and industrials joined in the market gains. But
technology has definitely been the big play, after a terrible 2022.U.S. equities are
trading at roughly 20 times earnings, far above long-term averages of about 16 times
earnings. In the event of a recession, those valuations could go even lower. Even if
people don’t expect a bad recession, I think most people are on the page that we’re
going to continue to slow down significantly. While I do expect the “pain trade” to
continue to be to the upside as the markets love to confound the masses, I just don’t
see how equities can have a second half as positive as the first half, even in the Big 7.
To me, nothing is more in control of these markets than inflation. While fundamentals
matter, they often don’t drive short-term markets. Markets are just “forward thinking”,
which can often drive short-term trends. While the Fed matters, markets will at times
ignore the Fed, especially if Mother Market feels strongly about the economy and
where inflation is going. This is why I have been following inflation data closer than
anything the past couple of months…
Last Friday’s CPI report shows a gathering trend of disinflation. Headline CPI did
better than projected and was up 0.2%, seasonally adjusted, month-over-month and
up 3.0%, not seasonally adjusted, year-over-year. (Consensus 0.3%, 3.1%).
CPI ex-food and energy (Core CPI) was up 0.2%, seasonally adjusted, month-overmonth and up 4.8%, not seasonally adjusted, year-over-year. (Consensus 0.3%,
5.0%). The lower-than-expected readings were partly due to a huge 8.1% month-overmonth decline in airline fares.
However, more broadly, the report confirmed generally moderate month-over-month
inflation in food (+0.1%), energy (+0.6%), new vehicles (unch), used vehicles (-0.5%)
and medical services (unch). Inflation was still strong in auto services, with auto
insurance rates rising by 1.7% and motor vehicle maintenance and repair climbing by
1.3% in a lagged reaction to a previous surge in new vehicle prices. Monthly shelter
costs grew more slowly but were still stubbornly high, with a decline in hotel rates
(-2.3%) and milder increases in rent and owner’s equivalent rent, both of which
increased by 0.4% compared to 0.5% in May. Shelter inflation is still stubbornly high.
With these numbers the forecasts now expect year-over-year consumption deflator
inflation to fall between May and June from 3.8% to 3.0% for headline inflation and
from 4.6% to 4.2% for inflation ex-food and energy. And when you look at the
significant deflationary effect of energy this year, this flows through many parts of the economy.
While markets will focus on a slightly weaker-than-expected June report, the more
important story is the strongly disinflationary trend that has cut year-over-year CPI
inflation by more than two thirds from its peak of 9.1% in June of last year. Base
effects mean that further declines in year-over-year inflation will be harder for the rest
of the year.
However, I am optimistic that we will see a further easing in the growth of shelter costs
and a sharp slowing in inflation in auto services as both negotiated rents and new
vehicle prices have barely increased in recent months. Because of this, I expect yearover-year CPI inflation to remain close to 3.0% and a little more stubborn for the rest of
2023 before descending to 2.0% over the course of 2024. Friday’s report will likely not
be enough to dissuade the Federal Reserve from their strongly telegraphed 25-basispoint rate hike at the end of this month.
However, a gathering trend of economic deceleration and disinflation may be enough
to convince the Fed that any further rate hikes in this cycle would be
inappropriate. Right now though, the markets feel like 1-2 more hikes are coming, then a pause and then the Fed starts going the other way on interest rates late in the year or early 2024 as depicted below.
I also feel like Real Rates could quickly flip and be at 2% in very short order, as
inflation continues to cool to 3%, with terminal rates reaching between 5.375-5.625%.
If this happens, then the above seems very likely, but will depend on shelter.
If real rates do move back to a positive 2% in coming months, the Fed will feel much
better about moving to at least a neutral position.
Any signals from the Fed that they are getting the disinflation message should be a
positive for equity and fixed income markets.
More major banks ahead
Bank of America and Morgan Stanley both post results next Tuesday. That follows
stronger-than-expected reports this past week from JPMorgan Chase and Wells
Fargo. Investors are closely watching banks after their struggles earlier in 2023 after
the collapse of Silicon Valley, and I am keeping an eye on the impact high interest
rates will have on deposits and lending.
A lot of the macro level data that I’ve seen in banking since Silicon Valley has
indicated that while lending has tightened a bit, it hasn’t tightened so much that it’s
squeezing small business or squeezing the economy in a way that’s meaningful, yet.
With that said, I am very interested in how much banks are setting aside in loan loss
reserves for commercial real estate and Wells Fargo set aside more than I presumed.
The week ahead will be light on major economic data. However, June retail sales data
is on the docket on Tuesday, and will give insight into the state of consumer spending. Investors are watching for any signs of weakness as fiscal stimulus savings are exhausted, and borrowers resume student loan payments in the fall.
Here are some things I will be watching closely next week:
Monday
8:30 a.m. ET: Empire State Index (July)
Tuesday
8:30 a.m. ET: Retail sales (June)
9:15 a.m. ET: Industrial production (June)
10 a.m. ET: NAHB housing market index (July)
Earnings: Bank of America, Morgan Stanley, Bank of N.Y. Mellon, Lockheed
Martin, PNC Financial, J.B. Hunt
Wednesday
8:30 a.m. ET: Housing starts (June)
Earnings: Nasdaq, Baker Hughes, Citizens Financial, Goldman
Sachs, Halliburton, Kinder Morgan, Las Vegas Sands, IBM, Tesla, Netflix
Thursday
8:30 a.m. ET: Initial jobless claims (Week ended July 15)
10 a.m. ET: Existing home sales (June)
Earnings: Discover Financial, Truist, American Airlines, D.R. Horton, Equifax, Johnson
& Johnson, KeyCorp, Snap-On, United Airlines, Newmont, CSX
Friday
Earnings: Comerica, PPG, Roper Technologies, American Express
Bespoke Investment Group noted that roughly 80%-85% of S&P 500 stocks are trading
above their 50-day moving average. When this happens, the S&P 500 has averaged a
6.13% gain in the following six months, based on data going back to 1990. Over the
following 12 months, that average gain goes up to 12.27%. These kind of statistics are
very powerful and this trend has been very strong…
Bespoke also noted that the index is positive more than 80% of the time in the six and 12
months following such strong market breadth. The firm added that this marks the first
time since last year that breadth has been that strong.
Bottom line: There’s a lot going right for the markets at the moment. However, if
inflation swings higher again and the Fed is forced to hike rates more than
expected, it could undo the recent progress made by Wall Street. This remains the
key indicator that I will be watching the closest.
Any signals from the Fed that they are getting the disinflation message should be a positive for
both equity and fixed income markets. The bonds I have put consumers in, will do very well if
rates come down much in the coming quarters or even years.
But with all the leading indicators trending down for the past 13 months, an inverted yield curve
like we have never seen, sticky inflation, and a slowdown on the horizon, is a recession right
around the corner? Many feel we have already been in a recession and the data certainly looks
that way. The consumer outside of services has definitely slowed down, especially on the
product side. Cyclicals, have just recently gotten out of their funk. Semis, traded down
significantly. Financials, were suffering for many months. The small caps continue to trade at a
huge discount, but that happens when markets are worried about debt and many of the small
caps are still not profitable.
While there has been “recession like damage” in many areas of the markets I wrote about
above, the lag of effects of Fed tightening, money supply tightening, and the economic
slowdown to come, might keep the Fed at bay from here.
The inflation data has definitely cooled off, as I wrote above. And if the recession is not
imminent, many people will be offsides and the “pain trade” will continue to be a positive market.
Remember that the interest rate hikes of 500 points are behind us and it appears that the Fed is
very likely to do two more 25-point hikes and then stop. But inflation continues to come down,
will they even do two? I am not sure a 5.625% terminal rate makes much sense if the core gets
down to below 4% in the coming three months and CPI gets down to below 3%. And with
shelter making up 70% of the CPI number right now, I am hesitant to think the Fed will go
beyond two more hikes and possibly bring down the entire economy, especially since the “lag
effects” are obviously starting to take hold. Additionally, I am starting to see banks become more
conservative when it comes to loans, and certainly getting rewarded with extra interest when
they do loan, which will also have its effects.
There are still many analysts that think we will have a 20% correction, so a “soft landing” will
keep many experts offsides.
With that said, we have never had negative Real Revenues and not had a recession, and it is
almost certain we will have negative Real Revenues this year. But recessions are very different
and a shallow recession is much different than a significant one.
As many of you know, fixed income, preferred equities, Mortgage REITs, and income funds all
play a bigger role with rates at the current level. I am finding many of these type of investments
that are giving 7-10% returns, without the risk of stocks. While I continue to invest in many stock
areas, covered calls, preferred stock, and fixed income of various kinds can provide less risk
and more income/yield in many portfolios. “Accruing Interest”, is again in vogue for portfolios,
after 14 years of low rates and higher risk in many of these other asset/sector classes. This
also means your portfolios are always worth more than it appears, as they accrue
interest/dividends on a regular basis.
Estate Planning: As I have been discussing with many of you, it is very important to “get your
house in order”. Unfortunately, I have to deal with a family’s loss every 2-3 years. Being setup to
bypass probate when possible, getting all accounts setup correctly, putting Durable Powers of
Attorneys in place, having a Living Will, having proper Guardianships are all very important to
have in place. Ensuring a family understands one’s key contacts and all business and personal
accounts owned, can save a lot of time and money when the time comes. Take the time to go
over these things with me.
We have never had this many interesting investment areas to choose from, for over a decade.
Now is the time to take advantage of this and take advantage of these opportunities, even if you
are more risk averse. I hope all of you are doing well and are enjoying your summer.
Warmest Regards,
Hunter Hardy CFP®
InvestmentHunter Wealth Services
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