As we go to print there are a number of news headlines of significance. Unconfirmed reports suggest that a Russian-produced missile hit a Polish village near the border of Ukraine, killing two Polish citizens. This incident sparked a flurry of NATO leaders declaring that all NATO territories must be defended and as a result, fanned fears of an escalation and/or expansion in the Russia-Ukraine conflict. News of this explosion in Poland aborted an early-day rally that had been kindled by better-than-expected third quarter earnings from Walmart Inc. (WMT – $147.44).
Later this evening former President Trump is expected to announce his intention of running for re-election in 2024. This could split the Republican Party which is already showing signs of post-election fatigue and upheaval. The midterm elections did not produce a red or blue wave, but it is expected to create a shift in leadership in Congress. Rick Scott (R – FL) announced he will run against Senate Republican Leader Mitch McConnell (R – KY) for the role of minority leader in the Senate. And if the Republicans edge out the Democrats in the House of Representatives, Kevin McCarthy is expected to take the role of Speaker of the House from the indefatigable Democrat Nancy Pelosi. New leadership in Congress is unlikely to generate a meaningful difference in policy, but it is reassuring that a divided Congress is usually seen as a positive for the equity market.
These news events took the attention away from the collapsed crypto exchange FTX which has dominated financial news in recent days. The exchange, among the world’s largest, filed for bankruptcy protection on Friday after traders pulled $6 billion in three days from the platform and rival exchange Binance abandoned a possible rescue deal. FTX is the highest-profile crypto blowup to date and bankruptcy filings indicate the exchange faces a “severe liquidity crisis” and could have more than 1 million creditors. This is a warning of possible liquidity issues in unsuspected places in the upcoming weeks. Meanwhile, it is possible that FTX founder and former chief executive Sam Bankman-Fried will face felony charges due to what might be “unauthorized transactions” on its platform.
News of the wayward Russian missile threw a curve ball in what appeared to be an improving outlook for the Russia-Ukraine conflict. The retreat of Russian troops from Kherson left Russia with no forces on the right, or western, bank of Europe’s third largest river that bisects Ukraine and flows into the Black Sea. This is a vital conduit for Ukrainian grain exports. In fact, there were unsubstantiated reports that an agreement might be possible between Russia’s Putin and Ukrainian President Volodymyr Zelensky. We believe this possibility contributed to the massive rally in the euro and the decline in the dollar last week. This prospect, coupled with short covering, were catalysts for the rally in equities last week.
Yet stocks rose for a number of reasons including financial headlines like “US Fed could soon start easing rate policy.” We found this headline to be very misleading. Using the word “easing” in terms of monetary policy translates directly into the prospect of the Fed lowering interest rates. However, in this case, the media is actually referring to the possibility that interest rate increases could get smaller. However, these are two very distinct and different concepts. We question whether this headline was intentional and thereby playing with investor psychology or was it simply a symptom of naïve and inexperienced journalism. We do not know, but we do know that the market responded as if interest rates were about to decline. This makes us nervous about the rally.
Higher Interest Rates Ahead
As noted, investors celebrated better-than-expected CPI data for October with a massive rally, but as seen on page 5, the improvement was minor. Headline CPI was 7.8% YOY in October versus 8.2% YOY in September. Core CPI rose 6.3% YOY versus the 40-year high of 6.6% recorded in September. PPI data was somewhat better since it is coming down from cyclical highs recorded in June. In October, finished goods PPI rose 11.2%, core finished goods rose 8.1% and final demand PPI rose 8.0% YOY. Yet clearly, these rates remain well above the long-term average of 3% and remain at the highest pace in 40 years.
What is important to emphasize is that core CPI (6.3% YOY) and core PPI (8.1% YOY) remain well above the pace of wage growth (4.8% YOY) and this means household purchasing power continues to erode. This has been and will be a factor that will weigh on economic growth in the coming months. See page 6.
Another consideration that will slow economic activity is steady monetary tightening. Recent inflation data indicates that the fed funds rate continues to be negative and as a result, the Fed is not expected to stop raising rates in the foreseeable future. See page 7. All in all, we question the validity of the discussion around a Fed pivot. Even though the pace of interest rate increases may slow, this has very different implications from a reversal in interest rates. Sentiment on monetary policy is too optimistic, in our view. The Fed will continue to raise interest rates and depress economic activity in coming months making a recession likely in 2023.
Meanwhile, consumer and business confidence continue to erode. NFIB’s Small Business Optimism Index declined 0.8 points in October to 91.3, the 10th consecutive month below the 49-year average of 98. Of the 10 Index components, two increased, seven declined, and one was unchanged. Small business earnings and sales are at levels last seen during the 2020 recession and employment plans are declining. See page 3. Headline University of Michigan consumer sentiment hit a record low of 50.0 in June before rebounding. Nevertheless, it fell from October’s 59.9 to 54.7 in November. Economic expectations in the University of Michigan and Conference Board consumer sentiment indices, as well as the small business survey, have been falling nearly every month in the last two years. See page 4.
Technically Good News
The 25-day up/down volume oscillator is currently overbought for the third consecutive trading day with a preliminary reading of 3.83. This is significant because bear markets rarely reach overbought territory and if they do the reading tends to be modest and brief. In sum, this will be a key indicator to monitor in the coming days to assess the strength of any advance in prices. A long and extreme overbought reading would change our view of this rally merely being a strong bear market rebound. We will keep you posted.
In the interim, it is clear that this bear market has defined a transition of leadership. The FANG phenomenon is over. This new cycle is shifting from classic growth to value, from large capitalization to mid-to-small capitalization, and from global to domestic. We continue to favor recession-resistant areas such as energy, utilities, staples, aerospace and defense and recession-proof healthcare.
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.