As we go to print, the US has formally charged former President Donald Trump with conspiracy to defraud the US, witness tampering, and conspiracy against the rights of citizens. Separately, the ratings agency Fitch downgraded the US government’s top credit rating to AA+ from AAA, citing three years of fiscal deterioration and a high and growing government debt burden. Globally, Russia announced that a drone hit a residential building in Moscow placing responsibility at the feet of Ukraine. A coup against Niger’s elected president is triggering evacuations of US and European partners and a Ukrainian official is alleging that Russia is responsible.
Of these events, the most important for US consumers and investors will be the downgrade of US government bonds. Rating changes can impact the demand for US government bonds at a time that the debt burden is high and the need to issue more debt becomes important. Higher interest rates are good for bondholders, but they also could negatively impact economic activity and PE multiples.
Great Economic News
However, equity investors are ignoring such threats and it is not surprising given the recent string of economic releases. It begins with the report that in the second quarter GDP grew 2.4% (SAAR) which was an increase from the 2.0% seen in the first quarter. In short, economic activity accelerated in the second quarter and this was much better than we, and most economists, expected. It was a surprising development particularly since corporate profits, real retail sales, and residential investment continued to decline in the same period. Personal consumption of nondurable goods and services was the source of strength in the second quarter and inventories were less of a drag than they were in previous quarters. See page 3.
As we have often noted, high levels of inflation are typically a precursor to a recession, and this has been a major concern in recent years. For example, the June 2022 GDP price deflator hit a worrisome 7.6% which was the highest level of inflation since the 8.4% reported in December 1981. However, the second quarter GDP report showed that this deflator fell to 3.6% in June, well above the Fed target of 2% but good news, nonetheless. Similarly, the monthly personal consumption expenditure deflator fell from 3.8% in May to 3.0% in June, its lowest level in 2 years. See page 4.
But the best news was found in reports on personal income and consumption. In June, personal income rose 5.3% YOY, disposable income rose a stunning 7.9% YOY, and our favorite benchmark, real personal disposable income, rose 4.75% YOY, up from 4.1% YOY in May. Personal consumption expenditures have been in a downward trend after hitting an unsustainable peak of 30% YOY in April 2021, but in June, PCE remained at a healthy 5.4% YOY pace. More importantly, the June acceleration in real personal disposable income is a positive sign for steady household consumption as we begin the third quarter. See page 5.
All the good news on the inflation front, combined with the 25-basis point hike in the fed funds rate in July, results in the real Fed funds rate increasing from 211 basis points to 236 basis points relative to the CPI. The real fed funds rate is similar when compared to the PCE deflator. What is important is that the combination is getting closer to the 300-400 basis points we believe the Fed is targeting for its monetary policy. But keep in mind that the strength seen in the economy also opens the door for the Fed to raise rates again on September 20 and perhaps even at the November 1 meeting. We believe the Fed will continue to raise rates until the real fed funds rate is at least 300 basis points and we do not believe the consensus agrees. This is a risk.
Politics Plays a Major Role
Equally important is the fact that 2023 is a pre-election year, and as is typical of a pre-election year, the incumbent party tends to pass stimulus bills to boost the economy. In this cycle, it comes in the form of the Inflation Reduction Act (IRA) which is actually a stimulus bill focused on supporting the green economy and technology sectors.
In addition, President Biden has circumvented the Supreme Court’s rejection of his sweeping student loan forgiveness plan and has launched its SAVE plan (Saving on a Valuable Education). This is a revision of a previous income-driven repayment plan, and the revisions include factors that base monthly payments on income. For many borrowers’ previous monthly payments will be cut in half and for some borrowers there will be no monthly bill. It is in fact a loan forgiveness plan of sorts. The Department of Education has stated that borrowers who sign up for the plan this summer will have their application processed before student loan repayments are expected to resume in October. In other words, the negative impact the end of the student loan moratorium might have had in the fourth quarter of 2023 has been eliminated to a large extent.
Given these developments we are raising our S&P 500 earnings estimates for this year from $200 to $212 and for 2024 from $220 to $230. These estimates remain slightly below consensus but are more in line with the fact that a recession in 2023 is less unlikely today than it was a month ago. See page 16.
However, even if we use S&P Dow Jones earnings estimates, which are higher than our forecasts, the current S&P 500 trailing PE multiple is 22 times and sits above all historical averages. We fear this means the equity market is priced for perfection. The 12-month forward estimated PE is 19.7 times, and when added to inflation of 3%, sums to 22.7. This 22.7 level is just below the standard deviation line of 23.8 which denotes an extremely overvalued equity market. See page 8. In other words, a lot of good news has been discounted in current prices. Also, keep in mind that the earnings season currently being reported took place during the 2.4% GDP economy, which was an improvement over the first quarter’s economic activity. If earnings do not show an improvement, it could dampen investor sentiment.
The charts of the S&P 500, DJIA, and Nasdaq Composite index are bullish and suggest the indices may, or should, be about to test their all-time highs. However, the Russell 2000 index has failed to break above the 2000 resistance despite numerous attempts in recent sessions. This is not conclusive, and the RUT may still break out, but it does leave the overall look of the market somewhat pivotal and uncertain at the moment. See page 10.
Similarly, the 25-day up/down volume oscillator is at a 4.03 reading this week and overbought for the third consecutive trading session. The good news is that the oscillator has had overbought readings for 10 of the last 21 trading sessions; however, to date, none of these overbought readings have lasted the minimum of five consecutive days needed to confirm the advance in the averages. Strong rallies should also include at least one extremely overbought day. Nonetheless, these requirements are what should be seen at a new market high and none of the indices have recorded new record highs. The rally has only produced new “cyclical” highs in most indices. See page 11.
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