Each earnings season is important since fundamentals are the underlying foundation for the equity market, and this is especially true for market rallies. And each earnings season has the potential of being a market-moving event, particularly if it is surprisingly good or bad. But in 2023, with the specter of a recession on the horizon, this earnings season seems even more important. To date, results have been mixed even though expectations have been dampened and earnings revisions have been heavily skewed to the downside prior to announcements.
Nevertheless, first quarter results may only be the tip of the iceberg in 2023. The mini-crisis in the banking sector which took place in March is widely expected to result in a credit crunch in coming quarters, and the impact of this will not be felt prior to the second quarter earnings season which will be reported in July and August. Therefore, investors will be forced to wait and see whether corporations are able to maneuver through the current minefield of inflation, rising interest rates, narrowing margins, and a hostile credit environment. Markets do not like uncertainty.
Our outlook is unchanged
Our outlook is unchanged. In our view, the risk of recession in 2023 is high since we believe the Fed’s policy of increasing interest rates will continue until inflation in the service sector and in wage growth has been broken. In other words, interest rates could go higher for longer. The banking crisis will increase the pressure on the economy, but we do not believe it will be enough to alter the Fed’s policy, at least, or until a recession is clearly in place. The consensus view of one more 25 basis point rate hike in May and the Fed is “done” could also be unwound if the rise in energy prices continues.
If energy prices continue to rise, the improvement seen in March inflation data will be a temporary phenomenon. And since earnings growth is apt to be modest or nonexistent this year, we believe the market will remain in a broad trading range in 2023. The best strategy for a rangebound market is to have core holdings of recession-resistant stocks, or companies with the most predictable earnings streams and dividend returns. However, a trading range market often includes a consistent rotation of sector leadership, and therefore shorter-term trading opportunities. Typically, value drives the rotation of leadership in a sideways market, and buying stocks which are depressed and holding them until the sector rallies is a tactical strategy for some investors. But this requires a nimble trading mentality and the discipline of selling once the stocks have been “discovered.”
Inflation Remains Sticky
March inflation data revealed a clear deceleration in pricing pressure, but it also showed a stubborn level of inflation in core prices. Headline CPI fell from 6% to 5% in March, but core CPI bucked the trend and rose from 5.5% to 5.6%. PPI for finished goods dropped from 6.4% to 3.2%, while core PPI eased only modestly from 6.8% to 6.5%. This discrepancy between headline and core inflation data is explained by crude oil’s 24.5% YOY decline in the same period. Meanwhile, import and export prices were both negative on a year-over-year basis for the second month in a row. In short, there has been good progress seen on the inflation front due to lower energy prices, yet core inflation remains high. See page 3.
Market pundits are focused on the decline in headline inflation in March, but the Fed Chairman Jerome Powell has been clear about his concern about wage inflation, particularly in the service-sector. This wage inflation will make the Fed’s job more difficult. As an example, the charts on page 4 from the Federal Reserve of Atlanta on the median year-over-year change in hourly wages show wage growth was 6.5% YOY in March. This was close to the highest growth rate seen since the survey began in 1983. The most recent cyclical peak was 7.4% YOY in June 2022. Wage inflation is nearly impossible to reverse without broad-based job losses – and job losses are the classic definition of a recession.
Total retail and food services sales fell for the second consecutive month in March but rose 2.9% YOY. Excluding motor vehicles & parts, sales rose 3.6% YOY. Gas station sales were the major drag on March sales, falling 14.2% YOY. As in the CPI, the falling price of crude oil and gasoline had a significant impact on March data. But as seen in the gasoline futures chart on page 9, this decline may be temporary. The only bright spots in the March report were nonstore retailer sales which were up 12.3% and food services and drinking places where sales jumped 13% YOY. See page 5.
Housing data was slightly better in March but remains in a longer-term slump. New residential building permits were 1.413 million (seasonally adjusted annualized rate) in March, down 25% YOY. Single-family permits rose 4.1% month-over-month but fell 29.7% YOY. Housing starts were 1.42 million, down 17% YOY. Single-family starts rose 2.7% month-over-month but fell 27.7% YOY. The March declines were concentrated in multi-family construction; however, both permits and starts in all categories were up from levels seen a few months ago. Homebuilder confidence inched up 1 point to 45 in April and though the index remains below the 50-benchmark denoting poor building conditions, there appears to be a bottoming process in confidence after the lows recorded in December 2022. See page 6.
Banking Crisis Aborted?
The Fed’s tightening policy and the historic 450 basis point increase in the fed funds rate in eleven months was destined to be disruptive to consumers and to the banking industry. The decline in commercial bank deposits totaled $967 billion at the end of March, and $473 billion of this exited the banking system in March alone. This drain on deposits was clearly at the crux of the banking crisis. However, this trend appears to be slowing a bit in April which should help stabilize the banks.
Bank loans through the Federal Reserve’s new Bank Term Funding Program fell from the April 5, 2023 high of $79 billion to $71.8 billion on April 12, 2023. This program was created to liquify the banking system and the fact that loans are being paid back suggests the liquidity crisis is abating. This is good news for the banks. However, it is unclear if higher interest rates and a weak commercial real estate sector is not going to be the next hurdle for banks in the months ahead. See page 7.
The rally in the WTI crude future is not getting much attention but it does have implications for inflation later in the year. A downtrend line at $80 in the WTI is at risk of being broken, which would be bullish for oil prices. Gasoline prices have already had a positive break in a 9-month downtrend line. Gold is tentatively breaking out of a major consolidation with resistance at $2000. And lastly, the dollar is falling, which also has inflationary implications for the coming months. See page 9. The 25-day up/down volume oscillator is at positive 3.34 this week, to date recording one day with an overbought reading of 3.0 or higher. This overbought reading follows a 12-day oversold reading that ended March 23. In short, a flip-flop action between overbought and oversold readings has emerged since February and it defines the current market condition as being neither bullish, nor bearish, but in a long-term sideways trading range. More importantly, the longer the current overbought reading persists, the more likely it will be signaling an intermediate-term top. See page 11.
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