As expected, the Federal Reserve did raise the fed funds rate by 25 basis points to a range of 4.75% to 5.00% last week. However, in reality, the Fed’s overall tightening policy is being offset by its need to increase liquidity in the banking system which has been under intense pressure since regulators took control of Silicon Valley Bank (SVB Financial Group – SIVBQ – $0.40) on March 10.
As the central bank moved quickly to add reserves to the banking system in the form of primary loans and through the new Bank Term Funding Program (BTFP), the Fed’s balance sheet expanded by nearly $350 billion dollars in recent weeks. See page 3. This quick response appears to have assuaged depositors who were concerned about the stability of regional banks. And while the crisis seems becalmed for the moment, the Fed’s action may also provide a few better days for investors. History shows that there has been a strong relationship between the Fed increasing its balance sheet (adding liquidity to the banking system) and rising stock prices. In sum, equity prices could rise in the near term.
However, we worry this will only deliver short-term comfort. The banking crisis could also result in tighter credit conditions for consumers and businesses and many forecasters are now suggesting that the Fed will cut rates in the second half of the year. This is a possibility, but only if it becomes clear that the economy is spiraling into a recession (which means corporate earnings will collapse!). Even so, the Fed may not cut rates quickly since history shows that high inflation has only been corrected by a recession. Unfortunately, the relationship between inflationary cycles and recessions is a strong one. Whenever inflation has risen more than two-standard deviations above the norm, or above 6.5%, the economy has suffered, not one, but a series of recessions. See page 4.
Higher for Longer
It is obvious that headline inflation has begun to decelerate but core inflation remains stubbornly high. Core CPI was only down 0.1% in February to 5.5% and this reflects the fact that pricing pressure is now concentrated in the service sector. In the CPI, service inflation was unchanged in February at 7.6% YOY. Service sector inflation less rent was 6.9% and pet services inflation rose 10.9% YOY. These are worrisome figures. The PCE deflator for February will be released Friday and it will be closely analyzed for any signs of service sector relief.
We believe the Fed governors when they state that they do not foresee an interest rate cut later this year. And the reasons are many. The Federal Reserve has never been this far behind the curve in terms of fighting inflation. Historically, a Fed tightening cycle began at the first sign of inflation and it ended with a real fed funds rate reaching at least 400 basis points. This latter point is quite different from the consensus view. What it means is that if inflation should fall to 3% this year (which we deem unlikely) the fed funds rate could rise to 7% by year end! See page 5. We doubt that interest rates will get this high, but we do expect the Fed to keep interest rates higher for longer than the consensus currently believes.
Using Technical Guidance
Most of the broad market indices are trading at prices that are close to levels representing the convergence of the 50, 100, and 200-day moving averages. See page 8. This convergence of moving averages should function as good support for the recent sell-off, however, as support, it is also pivotal. If the indices break below current levels it would likely trigger more selling. In other words, the next several weeks should be an interesting time for technical analysts; however, as we previously noted, the Fed’s recent quantitative easing should provide some near-term support for equities.
Meanwhile, our 25-day up/down volume oscillator is at negative 1.91 this week, which is a neutral reading after being in oversold territory for 12 consecutive trading days. This oversold reading follows an eleven-day overbought reading that ended February 8, and which represented a shift from a bearish to a positive trend, or at least from a bearish to a neutral trend. This new oversold reading clearly defines the market’s trend as being neither bullish, nor bearish, but in a long-term sideways trading range. See page 9. Keep in mind that in this 25-day oscillator, bull markets rarely reach oversold territory and bear market rallies rarely reach overbought readings. The current market is oscillating between overbought and oversold and therefore neutral. Other technical indicators such as the 10-day average of daily new highs and lows are more negative. We use 100 per day as the definition of a trend and new highs are currently averaging a weak 35 per day and new lows are averaging 189. See page 11.
The best example of the trading range we are expecting for the intermediate term is seen in the Russell 2000 index. See page 10. The Russell 2000 is heavily weighted in regional bank stocks, which some might say should make it a less predictive indicator; nevertheless, a bull market has never materialized without the participation of the financial sector. It is core to the economy. Therefore, we are closely monitoring a well-defined trading range in the Russell 2000 between support at 1650 and resistance at 2000. The RUT’s current price of 1753 is 6% from support and 14% from resistance, implying a slightly positive short-term risk/reward ratio.
S&P GICS Changes
ETF’s have become popular trading vehicles recently and we expect this to continue particularly since the trading range market we are expecting should see a continuous rotation of sector leadership. Therefore, we have reprinted a summary of GICS classification changes that took place in March. We expect these changes will impact not only the price performance of some SPDR ETF’s but it will also change the earnings in several categories. See page 7 for details.
The largest change will be seen within Information Technology, where eight constituents will move to the Financials sector and three constituents will move into the Industrials sector. From a market cap perspective, Visa Inc. (V – $220.33) and Mastercard Inc. (MC – $354.33) will be the largest changes and they will now rank as the 3rd and 4th largest constituents in the Financial sector and move into a newly created sub-industry titled ‘Transaction & Payment Processing Services’. The other sector impacted is Consumer Discretionary, which will see Target Corp. (TGT – $159.77), Dollar General Corp. (DG – $208.13), and Dollar Tree Inc. (DLTR – $141.66) all move into the Consumer Staples sector and the ‘Consumer Staples Merchandise Retail’ sub-industry. Target Corp. now ranks as the 9th largest constituent in the Consumer Staples sector. Financials will see the largest increase in earnings weight next quarter, rising from 17.6% to 19.7% (+2.1 ppt) due to Visa Inc. and Mastercard Inc., followed by Industrials (+0.3 ppt), which will be offset by the decline in Information Technology (-2.6 ppt). Consumer Staples will see its earnings weight rise moderately (+0.4 ppt) which will be offset by Consumer Discretionary (-0.3 ppt).
PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.