Inflation Changes Everything

There was a perfect storm of good news this week. It started on July 12 with the release of June’s CPI data. Headline inflation tumbled from 4% to 3% in June and core CPI fell from 5.3% to 4.8%. Both were better than expected. And though many subcategories of CPI showed price gains greater than 3% YOY, most trends appeared to be decelerating. The transportation sector showed prices falling 5.1% YOY and motor fuel fell 27% YOY. One surprise in June was that all items less food rose only 2.5% YOY, down from 3.6% in May. What most impressed us was that for the first time since March 2021, June’s inflation of 3% fell below the average long-term inflation rate of 3.5%. This was a significant hurdle in our view and a sign that the Fed’s target of 2% inflation is possible. See page 3.

The PPI was also released last week. It showed finished goods prices declining 3.1% YOY, although finished goods excluding fuel and energy rose 4.3% YOY. But in general, PPI data indicated that commodity prices are no longer driving inflation. Service sector inflation remains an issue, but less so in June. Service sector CPI, although still high at 5.7% YOY, was down from 6.3%. What could be encouraging for service sector inflation was the deceleration in wage growth inflation from 5.6% YOY in January to 3.8% in June. Also decelerating was owners’ equivalent rent which eased from 8.1% in May to 7.8% in June. In sum, there was good news in most CPI categories, and this cannot be underestimated in terms of Fed policy, household purchasing power, and its impact on PE multiples. See page 4.

The New Student Loan Forgiveness Plan

Good news continued with the Biden Administration’s new proposal on July 14 to replace a loan forgiveness plan that was recently struck down by the Supreme Court. This new complex repayment plan — called the SAVE plan or Saving on a Valuable Education plan — is expected to save borrowers thousands of dollars by keeping their monthly payments small – often as small as $0 — while preventing interest from exploding on balances that they owed. According to the Department of Education, borrowers would now pay back just $6,121 for every $10,000 borrowed. A DOE fact sheet states that borrowers who earn less than $32,805 a year ($67,500 for a family of four) will not have to make any payments and more than 800,000 borrowers could have their remaining loan balances erased. This latter point would be the equivalent of $39 billion in debt forgiveness.

Law experts believe this complex and multifaceted plan is likely to survive since it is a revision of an existing income-driven repayment plan (IDR) called Revised Pay As You Earn (REPAYE). The estimated cost to taxpayers for this plan ranges from $138 billion (DOE), to $230 billion (CBO), and to $361 billion (Penn Wharton Budget Model), depending upon the source. Yet regardless of the cost, the new SAVE plan is clearly another fiscal stimulus program. And to a large extent, it reverses the risk that faced many households on October 1 when the student debt moratorium was scheduled to end. As we had noted, the end of the student debt moratorium would have meant 44 million Americans would restart monthly debt payments averaging between $210 to $320 and this would have been a big negative for the economy at the end of the year. The Biden Administration has erased this risk.

Merger Mania

On July 18, a US court ruled that Microsoft Corp.’s (MSFT – $359.49) $69 billion takeover of Activision Blizzard Inc. (ATVI – $92.74) could proceed despite objections from the Federal Trade Commission. MSFT rose 13.76 points for the day, giving the Dow Jones Industrial Average a big boost. But it also was an important milestone for the merger-arbitrage sector of the financial industry which has been going through a rough patch. There are several mergers lined up in the technology industry that could now start moving through the pipeline. This lifted stock prices and Wall Street’s confidence. Another catalyst for MSFT was its announcement of Microsoft 365 Copilot, which is a major bet on the value of AI to Microsoft corporate clients. The stock responded favorably and its market capitalization of $2.71 trillion is now second only to Apple Inc. (AAPL – $193.73) which is valued at more than $3 trillion.

Global news was also good for inflation, for example, Canada’s inflation rate fell to 2.8% in June. And global growth is slowing. Argentina’s GDP fell 5.5% YOY in May, and some forecasters expect China’s economic growth slow to 3%. In the US, retail sales for June rose only 1.5% YOY which means that after inflation, retail sales fell 1.5%. This was the seventh month in the last eight months in which sales were negative on a year-over-year basis. See page 5. Historically, negative real retail sales are associated with declining nominal GDP and a recession. Inverted yield curves and monetary tightening are also recessionary. But the offset to these items may be that job growth remains resilient, and this may be the most important indicator of all.

Earnings and Valuation are weak

The July 14, 2023 “This Week in Earnings” report from IBES Refinitiv showed a $1.86 decline in 2023 consensus estimates last week. See page 6. It is important to mention this since the stock market has been responding positively to the early second quarter earnings reports, due in large part to the fact that IBES also writes that “80% of the 30 companies that have reported earnings to date have beaten expectations.” Yet IBES also indicates that the 2023 S&P 500 earnings estimate is now $217.28, and below the 2022 earnings number of $218.09, representing a decline in earnings growth for 2023. See pages 6, 8 and 15. The current IBES EPS estimate for next year is $244.74, reflecting a 12.6% increase, but up from an earnings decline in 2023. All in all, this is not the earnings backdrop one would expect when the SPX is up 18.6% year-to-date and the Nasdaq Composite is up 37.1%. It is more in line with the Dow Jones Industrial Average which is up 5.4% year-to-date, or the Russell 2000 index which has gained 12.2%.

According to our valuation model, the equity market has been trading well above the fair value range since the first quarter of 2021, or for the last two years. The last time this happened was early 1997 leading to the peak in March 2000. In short, the market remained extremely overvalued for three years. This is what characterizes a bubble. Our earnings forecasts are well below consensus, but we show the model with both S&P and DRG estimates, and the “overvalued” results are similar. See page 7. In our view, the market is at a turning point. It either continues to soar ahead led by a limited number of stocks, much like a bubble where fundamentals are disavowed, or it consolidates or retreats waiting for earnings power to support higher stock prices.

Technical Help The charts of the indices may help in this time of indecision. The technical patterns of the SPX and IXIC are extended after recent gains and look vulnerable near term. Conversely, the DJIA appears to have just broken out (thanks to MSFT). The RUT continues to trade within its long-term trading range between 1650 and 2000, but is closing in on the 2000 level. The answer to whether the equity market is going to make a dramatic run up to new highs or take a pause, may be found in the near-term action of the Russell 2000 index. A clear breakout in the RUT well above the 2000 resistance level would be a big catalyst for further equity gains. Either way, we would not chase the recent market leaders but would look for stocks with solid earnings growth and reasonable multiples.

Gail Dudack

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