Summary
The Federal Reserve is expected to make its final interest rate hike of the year on July 26. The expected 25 basis point hike is already reflected in the markets in my view.
The chances of a recession are lower than previously predicted, with Goldman Sachs among the most optimistic Wall Street firms.
The market's future performance is likely to be influenced more by earnings and AI validation and adoption, than broader macro factors, unless there is a significant increase in inflation.
At current levels, the S&P 500 is slightly overpriced and likely to move sideways in the next twelve months.
percentage to UP and Down arrow symbol icon. Interest rate, stocks, financial, ranking, mortgage rates and Cut loss concept
Cooling inflation and the final hike
The FOMC meets Tuesday and Wednesday, July 25th and 26th, for what most market participants expect to be the final hike of the year. The chances of a 25 basis point hike are as high as 99.2% according to the CME FedWatch Tool.
The 25-basis point hike would take the Fed Fund rate to 5.25% to 5.5%. The chances of a further hike of 25 basis points to 5.5% to 5.75%, two months out in the September are a slim 15.9%. Clearly, consensus forecasts seem to be veering towards a culmination of the massive 2-year tightening period that saw the Fed Funds rate rise from 0.25% to 0.5% to 5.5%.
Why do I and the vast majority of market analysts believe this is the final hike? Here are the main indicators that offer evidence that inflation has cooled significantly in the first half of the year.
A benign June CPI - The Consumer Price Index for June, was a relatively benign one, with headline CPI increasing only 0.2% MoM in June and 3% YoY, which was the smallest YoY increase since March 2021. To put it in context, the largest increase had been 9.1 % in June 2022.
Change CPI - Consumer Price Index
Change CPI (US Bureau of Labor Statistics)
Lower inflation expectations - Also aiding a more modest, stabilizing outlook was expected inflation from US consumers - that fell by 0.3% to low levels of 3.8% for one year, and only 3% for 3 years. This from a high of 6.8% in June 2023, so we have come a long way. Expected inflation is a fairly large factor affecting consumer behavior because it leads to postponement and abandonment of purchases until prices come down, and a huge reason why the Feds fought inflation so hard in 2022, was the fear of entrenched inflation. They had to get out there aggressively, especially after being late in 2021 and to a large extent it is done.
Lower used car prices - are a big factor in core CPI, a measure that the Fed watches more closely than the headline number. A drop of 4.2% in June was a welcome relief and the biggest monthly drop since March 2020. Clearly, the Fed's interest rate hikes along with supply chain improvements, have done significant damage by depleting demand for used cars, which have led to large inventories and wider discounted choices for consumers.
Lower PPI - The Producer Price Index as seen below also continues to trend downwards with just 0.1% increases in June for both the top line and the core number. Service inflation, which is by far the major factor of continuing inflation rose just 2.3% YoY and 0.2% MoM in June.
Change in Producer Price Index
Change PPI (US Bureau of Labor Statistics)
Wages and labor - While the July 7th, Non-Farm Payrolls report was not significantly positive for inflation, there were a couple of silver linings, which at least augur well for the future. Non-Farm payrolls came in at 209,000 net additions, lower than the 230,000 expected, and unemployment remained at 3.6%. However, April and May were revised lower by 110,000 taking down some of the pressure of an overheated labor market. While wage gains were modest with average hourly earnings rising MoM 0.4% and 4.4% YoY, they were a little higher than the 0.3% expected and unfortunately well below the cadence of 3.5% expected by the Fed to stop hiking.
I don't really expect wages or the labor markets to cool much faster, after all there are more than 9 Mn job openings and half that number to fill them. Besides, Covid 19 opened the floodgates for early baby boomer retirement and pushed out millions from the leisure and hospitality sectors to never return. Fortunately, the decline in prime age workers wasn't that steep and prime age workers, especially women, aided by more accommodative work from home policies and declining child care costs are mitigating that gap.
Treasury Secretary Janet Yellen, too believes that inflation is cooling and hopes to achieve the Fed's 2% target without wrecking the job market.
Treasury Yields fell after benign inflation reports, boosting the S&P 500 from 4,399 to 4,356, rising almost 7 days in a row. The 10-Year Treasury yield, which had moved up to 4.094 on July 7th after the June payroll report dropped to 3.73% two days ago, before settling at 3.84% on Friday. However, to put this in context, this is still a far cry from the low of 3.253% on April 6th in the aftermath of the banking crisis, which for a brief month had convinced everyone that the country was headed for a recession and that interest rate hikes were done. But even after staving off a banking crisis and skipping a hike in June, here we are - still looking a July 25 basis point hike, because the Fed needs to make sure they keep their foot down and not let up. Interest rates still have a long way to fall to keep the markets going in my view.
What Recession?
According to a Bloomberg survey, the chances of a recession are lower now at 50% than the 69% predicted earlier. And as for 2024, a Bank rate survey of economists still predict a 59% chance of a recession then.
Goldman Sachs been of the most sanguine among Wall Street firms and economists about a recession. They believe it is only 20% now and as far back as November 2022 gave lower odds of a recession, citing a soft landing as a likely outcome - a sentiment that looks more realistic now.
Most economists and analysts were predicting a recession for mainly two reasons:
a) They expected the Fed's massive 5% hike to bludgeon the economy into one and b) Terrible corporate earnings for 2023, due to demand being pulled forward, bloated inventories and higher wages from inflation.
The recession hasn't happened so far because:
a) Inflation contributed to companies' top lines mitigating the effect of higher wages and expenses.
b) Employment and payroll additions have stayed resilient in spite of massive tech and other layoffs as companies have hoarded talent.
c) SVB's and Signature banks' failures haven't wrecked the economy yet, and importantly the Fed backstop and takeover of First Republic by JPMorgan Chase (JPM) neutralized any contagion effects, boosting confidence and preventing a bank run.
The Federal Reserve of Philadelphia's updated survey of economists are forecasting small GDP increases of 1.3% for 2023 and 1% for 2024, which also don't indicate a recession and FactSet's latest estimate has the S&P 500 earnings staying flat at $219 per share for 2023 and growing 12% to $245 in 2024. My own estimate is in line at $222 and $238.
Since 1957, we have had only two recessions without an earnings drop.
The November 1973 to March 1975 recession was during the oil embargo and 1970s high inflation - we are nowhere close to that. The shallow recession of 1980 as defined by 2 quarters of negative growth and did not see earnings decline. In 1980 inflation peaked at 13.5%, (Yes, it's not a typo) before it started dropping - again inflation contributing to S&P revenues and earnings. That too was an anomaly.
Recessions and Earnings
Recessions and Earnings (Putnam Advisors, Bloomberg, NBER)
I would be on the "glass is half full" side if earnings continue to grow in 2024, in which case we should muddle through without a recession.
With reduced inflation and recessionary fears seeming to have abated - should we continue buying?
$E-mini Nasdaq 100 - main 2309(NQmain)$ Right now, the only major inflationary factor is the booming stock market wealth effect - loosening purse strings and keeping prices elevated. Obviously, the Fed probably doesn't like bubble-like valuations, which cause inflation, but short of further hikes, there is precious little of what they can do. Hikes to curb stock speculation would be hard to justify. What would the minutes say? "We wanted to slay the Artificial Intelligence speculators"?
Should we continue buying the SPDR® S&P 500 ETF Trust (SPY) or the S&P 500 (SP500)? Not so fast - Those who ignored the wise, top-down macro forecasters and dug their heels in, and instead followed the AI promise and the Magnificent Seven, Microsoft (MSFT $Microsoft(MSFT)$ ), Apple (AAPL $Apple(AAPL)$ ), Nvidia (NVDA $NVIDIA Corp(NVDA)$ ), Alphabet (GOOG $Alphabet(GOOG)$ ) (GOOGL), Meta Platforms (META), Amazon (AMZN) and Tesla (TSLA) have laughed all the way to the bank. The markets have already rewarded them with a 27% rise in the S&P 500 and a 39% rise in the Nasdaq Composite this year from their respective bottoms of 3,577 and 10,089. At 4,536, the S&P500 is at a P/E of 20.4 times 2022 earnings of $222, way above the past 5-year average of 17.5 and the 10-year average of 18.7. We are in overpriced territory.
We may be in for a soft landing and Goldilocks environment, but both are priced in my opinion, and any movement forward will be likely sideways.
What could move markets? Earnings would be key - The big drop of 2% on July 20th in the Nasdaq Composite was mostly because of 10% drops due to Tesla's and Netflix's (NFLX) "disappointing earnings". Earnings were actually not so bad but because they were priced to perfection, there was only one way to go - down. Unless there are blockbusters, hitting it out of the park beats, I would not expect stocks to move up. And even though I own five out of the Magnificent Seven, I'm okay with a reasonable correction, not planning to trade in and out.
The Bottom Line
A vast majority of benign inflationary data and the final hike by the Fed is already priced in the S&P 500 and the Nasdaq Composite. The only reason I believe the markets will move up more would be on wider AI validation and adoption in Q2-Q4 and less on broader macro factors - right now the only inflationary factor is the market wealth build up.
I don't expect the S&P 500 to return more than 5-10% from the current level of 4,536 in the next 12-18 months. Going forward, a consensus EPS of $245 for 2024 at a P/E of 19 takes us to 4,655 and a P/E of 20 gets us to 4,900. For me, the 10-Year Treasury yield would have to drop to 3% to justify a P/E of 20, A P/E of 20 implies an earnings yield of 5% and as a margin of safety, I would prefer to have an earnings yield premium of 2% to the 10-Year Treasury of 3%, which is closer to the historic average of the last two decades 2000-2020. A drop in interest rates is most likely still at least 8-12 months out, as analysts don't expect the Fed to start cutting rates before May 2024.
Source: seeking alpha
Comments