US Strategy Weekly: Fed Minutes – Inflation is Unacceptably High

Fitch downgraded its credit rating for long-term US government securities from AAA to AA+ on August 1, 2023, citing an erosion of fiscal governance and rising general government deficits. Moody’s cut the ratings on 10 mid-sized lenders on August 8^th. The Fitch Ratings service warned of a downgrade on more than a dozen banks on August 15^th and S&P Global Rating downgraded five regional banks on August 21^st, focusing on lenders with commercial real estate exposure. All these rating agencies indicated that some banks face a future risk to their balance sheets due to potential bad debts in the commercial real estate area, but all banks are dealing with liquidity pressure since many portfolios are drawing interest income of 2.5% to 4.5%, while needing to pay depositors 4.5% to 5.5% in savings and money market accounts. This may seem like an isolated problem within the banking sector, but it is not. Although there is no immediate crisis in the banking sector, there are strains in the system that are likely to continue longer than some expect. More importantly, the US economy cannot do well if the banking sector is not doing well. It never has. So, in our view, with this backdrop, it is not surprising that stock prices have been in a correction in August.

Trading Ranges Defined

The last year has produced a series of issues that have chastened both optimists and pessimists. From a longer-term perspective, the last 18 months have been frustrating for both the bulls and the bears. Our long-held view is that the stock market is in a broad sideways trading range, best defined by the Russell 2000 between support at 1650 and resistance at the 2000 level. The other indices have less obvious trading ranges, although it is clear that price action has been contained by resistance at the January 2022 peaks and support at the October 2022 lows.

Long-term trading ranges are not unique in equity history, but they have not materialized in a while. Since the March 2009 low, equities have been in a relatively consistent uptrend. In short, for most of the last 14 years, stock prices have been “trending” and as result, new investors might be unfamiliar with rallies that have limited leadership and declines that lack follow through. However, trading ranges are not unusual, and in our view the current trading range is a substitute for a more dramatic bear market.

Classic bear markets are often triggered by an unexpected event that shakes investors’ confidence and this event becomes the catalyst for an unforeseen earnings decline. A dramatic bear market ensues and produces a relatively sudden but quick repricing of risk. A trading range is simply another way of repricing risk and can be a subtle substitute for a bear market.

In the current environment, a trading range is a way for earnings to catch up with prices. Earnings for the S&P 500 declined on a year-over-year basis during the second, third, and fourth quarters of last year. Earnings are now expected to grow modestly from these much-reduced levels; nevertheless, the outlook for earnings growth remains uncertain.

If we look at S&P Dow Jones operating earnings data, it shows that the four-quarter sum in earnings peaked in March 2022 at $210.16. The S&P Dow Jones consensus estimates show that four-quarter earnings could reach a new high by the end of the 2023 third-quarter earnings season, with earnings of $212.89. However, these are estimates and data shows essentially no earnings growth for most of 2022 and 2023. In sum, prices moved higher in 2023, but the fundamentals did not. The recent trading range is a way for earnings to eventually catch up with stock prices. In our view, the catalyst needed for stocks to break out of this trading range is for the Fed to successfully tame inflation and this will take more time. In the interim, we believe focusing on stocks with reliable earnings streams and reasonable PE multiples will be the best way of managing through this environment. 

FOMC September 20

One reason to believe the Federal Reserve will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 3, in previous cycles, the fed funds rate typically increased ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend, and this allowed inflation to become ingrained in the service sector. Since service sector inflation is less commodity driven and more salary driven, it is more difficult for the Fed to control. It also explains the Fed’s attention to service sector inflation. Meanwhile, it is important to note that the real fed funds rate usually reaches 400 basis points in a tightening cycle, and though the real rate has been rising, it is now only at 230 basis points. In short, we believe another rate hike is likely on September 20 and we do not believe this is discounted in stock prices.

The path of interest rates is important to the economy since it will impact both the auto industry (see page 4) and the residential housing market. The National Association of Home Builder Confidence index fell from 56 to 50 in August, which is not surprising, since the June NAR Housing Affordability index fell from 93.7 to 87.8, the lowest level since January 1984. This decline in affordability was before the Fed’s July rate hike! The June decline was attributed to a combination of median family income ratcheting down to $91,319, the median price of a single-family home rising to $416,000 and the NAR mortgage rate increasing 28 basis points to 6.79%. See page 5.

Although the housing market has been in a slump for almost two years, it is possible that housing is about to slow further as interest rates rise and remain high. This risk can be seen in the fact that both existing and new home prices have stopped increasing and in recent months have registered year-over-year declines. Also interesting is the fact that home prices and retail sales have been highly correlated over the last 60 years, and both appear to be on the cusp of a negative cycle. See page 7. Some may think that these are reasons for the Fed to pause, but underlying these risks are a tight labor market and wage growth that recently has exceeded the pace of inflation. We believe the Fed will remain higher for longer in order to be confident that inflation will reach its target of 2%. 

Technical Update

As a result of the recent weakness in the equity market, all the popular indices are currently trading below their 50-day moving averages and are about to test their 100-day moving averages. However, the Russell 2000, is about to test its 200-day moving average which is now at 1843. We would not be surprised if all these moving averages were broken in the near term since this would be typical of a long-term neutral trading range environment. See page 9. 

The 25-day up/down volume oscillator is at negative 2.05 this week, which is at the bottom of the neutral range. It is close to registering an oversold reading of negative 3.0 or less, which would neutralize the recent unsustained overbought readings. Meanwhile, the 10-day average of daily new highs is 54 and new lows are 111. This combination turned negative this week since new highs fell below 100 and new lows rose above 100. All of the above is normal for a trading range market.

Gail Dudack

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