US Strategy Weekly: Tighten Now or Later

Friday’s employment report will be important since it will set the stage for the Federal Reserve’s next FOMC meeting scheduled for June 15 and 16. The June meeting will be accompanied by a Summary of Economic Projections and economists will be checking this closely to see if estimates have changed and if so, might this mean that a pivot in monetary policy is on the horizon. In short, it could be a market moving event. April’s job report showed a disappointing increase of 266,000 new jobs, which was less that the average gain seen over the previous three or six months. May should see a nice recovery in the labor market since most states are now relaxing or eliminating pandemic restrictions. However, if the release shows an extraordinarily strong job market this could also spook investors who are worried that a strengthening economy, coupled with a high savings rate and pent-up demand, could fan the flames of inflation. We worry about this as well.

Federal Reserve officials continue to emphasize that any inflation will be transitory, but to some market observers this translates into the possibility, or likelihood, that the Fed is apt to fall behind the curve. If so, the Fed would need to raise rates even more aggressively sometime in the future in order to tame inflation. This is an important factor since most economic recessions in the US have been preceded by repeated Fed tightenings. In fact, this is the underlying principle in Edson Gould’s famous “three steps and a stumble rule.” Edson* was a well-respected market technician and stock market historian of the 1930-1980 era, yet some technicians do not believe his rule is valid today. We have found that to make this rule useful it is important to observe the number of Fed fund increases within a rolling twelve-month period. Three or more fed rate hikes, particularly if they are large, within a twelve-month period has always been followed by a weak stock market in the subsequent six and twelve months and it is usually in conjunction with a recession. For this reason, among others, it is important that the Fed not delay in addressing inflation and find itself running to catch up to control the cycle.

In our view, inflation has always been the main risk for equity investors in 2021 since it means both a change from easy monetary policy, a rise in interest rates and a decline in average PE multiples.

Inflation does not have to be a disaster for equities, however. Stock prices can rise along with interest rates as long as earnings increase enough to compensate for the rise in the risk-free rate. Good earnings growth appears to be a strong possibility for this year and next; therefore, the greater risk over the next twelve months is more likely to be the Fed. If the Fed delays a shift in monetary policy too long, it could find itself having to tighten more aggressively to stem off inflation; thereby triggering a recession. The Fed’s favorite benchmark for inflation is the personal consumption expenditures (PCE) price index and this revealed a 3.6% YOY rise in April after being up 2.4% YOY in March. We were not surprised by this big jump in the PCE deflator since it puts it in line with all other inflation measures which now uniformly exceed 3% YOY. The implications for monetary policy are potentially huge. To demonstrate the pressure that this places on the Fed we have a chart of the real fed funds rate as compared to the PCE deflator. See page 7. The real fed funds rate is currently negative 3.5% and reflecting the “easiest” policy seen since February 1975, during the 1974-1975 recession. This negative real fed funds rate will prove to be far too stimulative as people go back to work and the economy recovers. It will force the FOMC to change its verbiage and actions.

Only time will tell if inflation is transitory or not. Meanwhile, we believe the healthiest scenario for the equity market would be either a 10% correction or a sideways market over the next few months. If not, the inevitable shift in Fed policy will trigger a correction that could exceed 10% in the SPX. Seasonality also suggests the stock market may be about to take a pause. June tends to be an underperforming month in the annual calendar and ranks 9th or 10th in terms of performance in most indices. See page 9.

A Mix of Economics

Housing has been a main pillar of the economic recovery during the pandemic. However, the pending homes sales index for April fell from 111.1 to 106.2, which was its lowest level since May 2020. April’s survey leaves the index below its long-term average of 108.7. This decline in housing sales is likely to continue, particularly if home prices continue to rise. Buyers are apt to be priced out of the market. In April, the median home price for a single-family home rose 20% YOY, the largest twelve-month increase in National Association of Realtors records going back to 1999. Mortgage rates remain historically low but have also been rising, which will become another handicap for first time buyers. See page 3.

Stimulus checks boosted personal income 30% YOY in March; but in April personal income fell 13.1% month-over-month, which translated into a small 0.5% YOY increase. Disposable personal income rose 33.3% YOY in March but fell 1% YOY in April. The savings rate remains high but erratic at 14.7% in February, 27.7% in March and 14.9% in April. See page 4. The most interesting part of personal income is pre-pandemic total compensation which does not include transfer payments. Total compensation peaked in February 2020 at a seasonally adjusted annualized rate of $11.82 billion; however, despite the drop in employment, we were surprised to find that total compensation achieved a new record of $11.88 billion in November 2020. In April, total compensation rose to an all-time high of $12.3 billion. The same pattern is true if we look solely at wages or supplements for employees in the private sector. This underlying momentum in wages seen since November 2020 challenges the need for further fiscal stimulus in 2021. It also indicates that further stimulus could over-stimulate the economy. See page 5.

Earnings and PE Multiples

Both Refinitiv IBES and S&P Dow Jones consensus EPS estimates for the SPX for 2021 and 2022 continue to rise which is favorable and provides support for the equity market. The current IBES and S&P estimates are $189.61 and $186.59 for 2021 and $212.12 and $209.50 for 2022, respectively. This means the market is rich, but not overvalued, in a low inflation environment where a 20 PE multiple is justifiable. However, if inflation is 3.5% or higher PE multiples are likely to fall back to average or lower. The long-term average PE multiple for the SPX based upon forward earnings has been 18.2 times and on trailing 12-month earnings the average PE is lower at 15.8 times. This points to why inflation is a dilemma.

Market Data

To date, 2021 has been most notable for its leadership shift, away from the technology-laden Nasdaq Composite Index and small capitalization Russell 2000 index and toward cyclically driven inflation sectors such as energy, materials, financials, and REITs. See page 16 for sector performances year-to-date. This shift is producing new highs in the SPX and DJIA and sideways patterns in the IXIC and RUT. See page 12. There are also disparities in macro technical indicators. The NYSE cumulative advance decline line made a record high on June 1 confirming a bull market, whereas the 25-day up/down volume oscillator continues to languish in neutral. At present this indicator is suggesting the indices are moving to new highs but on lower volume and less robust buying pressure. This is a sign of waning investor demand and therefore is a warning. Again, a sideways or correcting market would be the healthiest scenario near term. *https://www.ofeed.com/Star%20Traders/1135

Click to download