The Federal Reserve did not raise interest rates last week, but Chairman Powell’s prepared statement and his question-and-answer period were sufficiently hawkish to convince investors that another interest rate hike may be needed this year. The dot plot revealed that most governors expect the fed funds rate will still be above 5% by the end of next year. And Chairman Powell’s comments underscored that interest rates are not likely to come down for a long time. None of this surprised us, but this had an impact on sentiment since there has been a staunchly held view that both inflation and interest rates would be coming down in the foreseeable future.
In the wake of the Federal Reserve’s hawkish stance, the benchmark 10-year Treasury yield rose to a 16-year high above 4.5%. More recently, Minneapolis Federal Reserve Bank President Neel Kashkari, one of the more dovish Fed governors, stated that there is a 40% chance the Fed will need to raise interest rates “meaningfully” to beat inflation. He indicated there was a 60% chance that one more rate hike would bring inflation in line and maneuver the economy to a soft landing. Kashkari gave no percentage for a recession. However, in our view, only if “it is different this time” will the US economy be able to escape a recession before inflation is once again under control.
Higher for Longer – Inflation and Interest rates
We continue to repeat several charts that show the history of inflation, interest rates, and the economy, since these charts are at the foundation of our stance. On page 3, the charts show that whenever inflation reaches a high level, such as the 9% seen in June 2022, inflation has declined, but only in concert with a recession. A tighter monetary policy has always been the key to reducing inflation, but the cycle of tightening typically ends only after the real fed funds rate reaches a minimum of 400 basis points. With inflation now at 3.7%, this suggests a 7.7% fed funds rate. We doubt that the fed funds rate will reach 7% or more, but we do believe the Fed is behind the curve and needs to keep rates higher for longer than most investors expect in order for monetary policy to be successful. This will also raise the risk of a recession.
Jamie Dimon, CEO of JPMorgan Chase & Co. (JPM – $144.93) told the Times of India in an interview this week that many businesses and investors were not prepared for a worst-case scenario in which interest rates hit 7% and stagflation grips America. Again, the risk of a recession is greater than Kashkari’s zero. We think there is a better-than-even chance that a recession is on the horizon, and it does not have to be a long debilitating recession, but it is part of a normal economic cycle. A recession would have come earlier and probably be over by now, if it were not for the multiple stages of fiscal stimulus put into place in the last three years.
One thing is clear – inflation is not apt to come down quickly. After 12 months of a disinflationary trend in the CPI, and after 8 months of negative year-over-year pricing in crude oil, both trends began to reverse in August. Sequentially, the CPI was up 3% YOY in June, 3.2% YOY in July, and 3.7% YOY in August. The PPI for finished goods was 2.2% YOY in August, the first positive year-over-year gain in four months. Oil was still negative in August on a year-over-year basis, and this helped to dampen headline CPI, but to date, it is up 14% YOY in September. This is likely to fuel price increases in September. Moreover, the technical chart of light crude oil shows that it has broken above a downtrend line and has no significant upside resistance prior to $100 a barrel. This is good news for energy sellers but bad news for inflation. See page 4.
The Impact on the Economy and Earnings
Interest rates are up over 500 basis points since the end of 2021 and the lag effect is beginning to be felt. The housing sector is showing weakness again with a 15% YOY decline in existing home sales in August and a 5-point decline in the National Association of Home Builders index. This puts the NAHB index below 50 for the first time since the banking crisis this Spring. New home sales in August were down 8.7% from July’s level, but still up 5.8% YOY. Housing affordability has been declining substantially this year as mortgage interest rates continue to rise. See page 5. These are signs that “higher for longer” could translate into a weaker economy ahead.
A weaker economy has implications for corporate earnings. There is a close relationship between GDP corporate profits and S&P reported earnings and both were negative on a year-over-year basis in the first two quarters of 2023. However, the consensus earnings growth forecasts for the S&P 500 for the next four quarters look rather arbitrary to us with analysts plugging in a 10-12% growth rate. A 10% earnings growth rate is a typical estimate whenever the outlook is unknown. See page 6.
However, there are many variables in earnings growth rates. GDP data shows that nominal final sales fell sharply in the second quarter as fiscal stimulus is fading. Plus, GDP after-tax margins have been slipping in recent quarters. Strangely, S&P operating margins increased as GDP profit margins decreased. This disparity between GDP and S&P profit margins has happened in the past and it is often a symptom of tax law changes or financial engineering, neither of which has longevity. See page 7. This data suggests that there could be both a decline in revenue and a margin squeeze ahead for corporate America.
Lastly, valuations appear stretched. When we index nominal GDP, GDP corporate profits, S&P earnings, and the S&P Composite index on one chart, it is easy to see when, or if, profits and/or the SPX become extended relative to GDP growth. There can be reasons for this disparity such as an increase in productivity from both workers and technology. However, the current disparity between the SPX and GDP is greater than that seen at the 2000 peak in equities. The March 2000 peak was also a time of great technological changes, but it ended in a dot-com bubble. Our valuation model tells a similar story since it suggests equities are nearly as overvalued as they were in 2000. See page 8.
Technically, Still in a Trading Range
What looked like a consolidation phase last week turned into a clear downtrend this week, with the Dow Jones Industrial Average and the Russell 2000 index now trading below their 200-day moving averages. The S&P Composite and the Nasdaq Composite are still trading above their 200-day moving averages but look like they might be about to test these levels in the near term. Nevertheless, the major patterns in the market remain characteristic of a long-term neutral trading range. This trading range is best seen by the Russell 2000 index which has support at 1650 and resistance at 2000. See page 10. There has been some clear deterioration in breadth data this week. The 10-day average of daily new highs fell to 65 and new lows rose to 199. This combination is solidly negative this week with new highs below 100 and new lows well above 100. In addition, the NYSE advance/decline line is 33,612 net advancing issues from its November 8, 2021 high. This disparity fell below 30,000 in July for the first time in two years; but in recent days it increased to more than 30,000 issues once again. See page 12.
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