Thought to ponder…
“It is never wise for a speculator to fit his facts to his theories.”
Edwin Lefevre
Reminiscences of a Stock Operator
The View from 30,000 feet
As the week began, demand picked up for U.S. Treasuries based on geopolitical uncertainty resulting from the Hamas attack on Israel, driving yields lower. Helping cool yields, a parade of Fed speakers took stage with a uniform message – tighter financial conditions are doing the Fed’s work for them, potentially negating the need for further hikes. Equities responded by moving higher, doing what they’ve been doing since July – inversely following yields. As the week progressed, attention turned from geopolitics to economic data and the first big earnings reports for Q3. Economic data centered around inflation with PPI and CPI, which both signaled persistence of inflationary pressures that can be traced to the impact of the recent spike in oil prices and the surprising slow impact on CPI of the weaker housing markets. Financials led the way for earnings, with reports from JPMorgan Chase ($4.33 vs $3.95), Wells Fargo ($1.48 vs $1.24), Citigroup ($1.63 vs $1.23) and Blackrock ($10.94 vs $8.34). The strong start from Financials helped propel expectations for S&P500 Q3 earnings from negative to positive year-over-year growth, and possibly setting an anchor a Q4 rally.
Takeaways from last week’s data – more inflation, less confidence
It’s not a mystery why the employment market has been persistently strong: expanding economy + stagnating labor force growth
Probable outcomes for the Israel/Hamas conflict
The most Frequently Asked Question from clients this week: What happened to the year of the bond?
Takeaways from last week’s data – more inflation, less confidence
Both CPI and PPI notched higher than expected.
Headline CPI year-over-year Actual 3.7% vs Survey 3.6%
Driven by owner’s equivalent rent which increased 0.54%, accelerating over the last three months, and hotel rooms which increased 3.7% for the month. Given the recent sharp increase in mortgage rates and downtrends in Zillow data, the increase in OER, looks to be a timing issue.
PPI Final Demand year-over-year Actual 2.2% vs Survey 1.6%
Driven by food prices which increased 0.9% and energy prices which increased 3.3%, and a massive jump in the trade services component, which can be attributed to surge retail margins for building materials, which is highly volatile and unlikely to repeat.
Potentially more concerning than the small upside surprises in inflation data were the upticks inflation expectations.
NY Fed 1-year Inflation Expectations Actual 3.67% vs Previous 3.63%
University of Michigan 1-year Inflation Expectations Actual 3.8% vs Previous 3.2%
University of Michigan 5 to 10-year Inflation Expectations Actual 3.0% vs Previous 2.8%
Meanwhile confidence continued to trend lower with the University of Michigan Consumer Sentiment falling from 68.1 to 63.0, disappointing expectations and following the trend in NFIB Small Business Optimism, which too fell and disappointed expectations.
The biggest question is the degree to which the Fed is willing to look through energy and housing
Employment strength = expanding economy + stagnating labor force growth
On 12/31/19 GDP in nominal Dollars was $21.9t. As of 6/30/23, GDP had grown to $27.1t, expanding 23.7% since just prior to the pandemic.
S&P500 earnings for the year of 2019 were $163.13. S&P500 earnings for 2023 are expected to be $221.06, expected to grow 35.5% since just prior to the pandemic.
The S&P500 Index closed on 12/31/23 at 3,231. The S&P500 Index closed on Friday at 4,328, increasing 34.0% since just prior to the pandemic.
The US Total Labor Force closed the year of 2019 was 159m people. The most recent reading on the US Total Labor Force on 9/30/23 was 162m people, increasing only 1.9% since just prior to the pandemics.
Let’s play a game. Which one of these numbers doesn’t belong? While I’m not implying that there should be symmetrical relationship between the growth in the economy, stock market and the labor force, the fact of the matter is that for the 10 years prior to the pandemic the Total US Labor Force had grown on average 1.4% a year, while nominal GDP expanded at average annual pace of 4.1%. In the nearly four years since the pandemic the relationship between growth in GDP and growth the labor force has disconnected. In the 10 years prior the pandemic the average annual ratio of Nominal GDP to US Labor Force growth was 2.9x, and it has exploded to 12.5x. Is it any wonder that there seems to be a labor shortage?
Retirees have left the labor force but continued to boost consumption
Probable outcomes for the Israel/Hamas conflict
The following analysis was provided by Bloomberg Economics article titled – Wider War in the Middle East Could Tip the World Economy into Recession.
The analysis attempts to analyze the impacts on the global economy based on how many countries are drawn into the conflict, both directly and indirectly, highlighting three possible scenarios:
Confined War
Hostilities largely confined to Israel and Palestinian territories
Proxy War
Spill-over to Lebanon and Syria and proxy war between Israel and Iran
Direct War
Military exchanges between regional enemies and Iran
In attempting to determine the economic outcomes, Morgan Stanley’s Strategist, Michael Zezas may have said it best this past weekend when he wrote: “As a student of geopolitics and a strategist whose practice relies on unraveling its complexities, what I can say with confidence is this: there’s no obvious path from here, so we must be humble and flexible in our thinking.”
Bloomberg Economics analysis of impacts of different paths the war may take
FAQ: What happened to the year of the bond?
I was reminded this weekend of a headline I read in December of 2022 titled – The Year of the Bond.
The article, published by New York Life, attempted to explain why disinflation and lower rates in 2023 would lead to falling bond volatility and reversion to the mean for total bond returns, after the worst year in the history of the US bond market.
The year hasn’t played out that way. Instead, the Fed has continued to march interest rates higher, albeit at a slower pace, and Treasury prices, pressured by issuance and a clown show in Washington that has left Congress looking disorganized an incapable of showing fiscal responsibility, have continued to trend lower, with jaw dropping volatility.
The average value of the Move Index, which measures US bond market volatility based on options pricing of interest rates swaps, averaged 120.06 in 2022. That was almost double the 64.67 average of the previous 10 years.
The Move Index closed at 128.33 on Friday, having averaged over 130, since the beginning of the month.
However, as interest rates have continued to climb, the arguments that were highlighted by bond mavens at the end of 2022 are even more relevant today. In a recent analysis by F/M Investments, the 10-year US Treasury total return would be projected to be +16.4% in 12-months if interest rates were to fall 150 bps.
More aptly, 2023 will likely instead go down in the history books as the year of the Magnificent 7. As recently as a week ago, the Magnificent 7 was responsible for over 100% of the gains in the S&P500, with the other collective 493 stocks, in aggregate, contribution being negative.
Bonds are storing potential energy, while the Magnificent 7 are displaying kinetic energy
Putting it all together
Last week’s economic data did little to change the trajectory of the Fed. As it’s been said, the last mile of inflation is going to be the hardest mile to deliver on. The trend for inflation is still lower but path is littered with landmines, especially with continued volatility in energy prices, the massive time lag in housing and increased geopolitical turmoil.
Geopolitical tensions are expanding, and the likely impact on global growth is negative, while financial conditions have tightened, further taking energy out the system and increasing the likelihood of a slower path for growth in the coming year. However, war has historically been inflationary, so the downtrend in growth may not necessarily be accompanied by disinflationary forces.
Earnings from Financial provided the first signs that economic momentum is continuing, while jobless claims remain persistently strong, signaling that there may be at least one or two more quarters of growth in the tank.
Since the pandemic, the story inflation has continued to take unexpected turns. What began as goods inflation based on too much money in the system with too few goods being produced, gave way to services inflation as economies reopened and pent-up demand drove a spike in services. Then Russia invaded Ukraine and caused a spike in energy prices. While this was happening, companies took advantage of the situation by raising prices and padding their margins, adding a wave a profit led inflation that seeped into the equity markets. There appears to be an end in sight to most of these drivers, just as Hamas attacked Israel, adding another wildcard to the inflationary backdrop.
From a strategy and timing perspective, we still view the situation as what we call “a picking up nickels in front of a steamroller market”. In the short-term, economic momentum may be adequate to continue to promote consumer and corporate spending and sustain growth, but like a python constricting its prey, higher rates will eventually squeeze the life out of the economy.