The Federal Open Market Committee (the Fed), as widely expected, decided this week to maintain short-term borrowing costs between 5.25%-5.5%. Despite its acquiescent pause, the Fed released its forecast for future rates which sent a message to markets that expectations for significant rate cuts in 2024 may be too optimistic. Currently, the market expects the Fed to maintain the current level of rates before beginning rate cuts in mid-2024 (with three total 0.25% cuts priced in for full-year 2024).
Throughout the year, we have expected core inflation to persist above the Federal Reserve’s 2% target for longer than what the current market expectations suggest…leading to pain for markets, especially in highly interest-rate sensitive asset classes such as technology stocks and long-term bonds. Asset prices may be beginning to reflect in this “higher for longer” scenario.
As students of economic cycles, we acknowledge that the remedy for elevated inflation might materialize through a combination of decelerating economic growth and a less robust labor market. Despite the prevailing narrative in financial media advocating for a “soft landing,” we retain a sense of caution regarding the possibility of a recession on the horizon.
In our assessment, investors who are well-prepared stand not only to endure the challenging conditions but also to uncover more appealing risk-to-reward prospects amid this evolving landscape.
As we discussed in our Podcast this week (click here to view recent PCM podcasts – most recent episode available soon), markets celebrated CPI and PPI inflation numbers this week showing signs of moderation. Headline inflation moderated to 3% year-over-year, while core inflation came in at 4.83% (mostly reflecting lower energy prices since summer ’22). Small-cap stocks performed better on the week than their large-cap counterparts, extending recent outperformance (small-caps +11.7% v. large-caps +8.5% since June 1st). Markets will turn their eyes next to Q2 earnings reports. While still early in the reporting season, blended earnings for the S&P 500 show a year-over-year decline of -7.1%. If this holds, it will be the weakest quarter since Q2 2020 and the third consecutive negative quarter. Analysts are, however, expecting a rebound in earnings into year-end and for 2023 earnings to be finish the year roughly equivalent to the number posted in 2022, and 2024 to post a 10% increase in earnings. Somewhat incongruous with this estimate, however, is the continued expectation that the Federal Reserve will begin cutting interest rates in early 2024. Absent a “hard landing” recession, policy makers may be content to leave rates at currently restrictive levels. While the Fed is broadly expected to raise rates at its late-July meeting, it may yet surprise markets with a hawkish message that investors should prepare for “higher for longer.”
After leading the markets to the downside last year, US large-cap stocks have been the best performer year-to-date. The equal-weighted S&P 500 index is +1.14% for the year vs. a +9.44% rally for the market-cap weighted S&P 500 index. On a single stock basis, Nividia and Meta (formerly Facebook) have more than doubled in value over the course of the year. Two main factors are responsible for the rally in tech shares:
The AI Boom: investors have been enamored with companies that may be exposed to the wave on Artificial Intelligence (AI) applications. An analysis by Societe Generale finds that removing the 20 stocks most widely owned by AI-focused funds would reduce the S&P 500 performance by roughly 10% year-to-date).
Expectations of an Upcoming Fed Pivot: Despite efforts from Chairman Powell and other Fed presidents to convince the markets that the Fed may indeed continue to hike rates if inflation does not return to the 2% level, the market expects central bankers will soon be cutting rates. Current market pricing reflects the assumption that the Fed will cut short-term borrowing costs by 0.5% by year-end. This shift to (more) accommodative monetary policy will likely benefit the interest-rate sensitive technology sector.
Investors may be well served to closely examine their risk tolerance and time horizon before chasing after returns in tech stocks, however. We highlight a few factors which could derail the rally:
Stagflation: slowing growth (whether an official recession or not) combined with persistently sticky inflation will both challenge earnings for tech stocks and valuations. The Fed may be disinclined to acquiesce to the market’s desire for lower rates and the lofty valuations supporting the tech rally may be forced to moderate.
Valuations: investors must not only consider the quality of the companies that they own, but also the price they pay to own those companies. U.S. “Mega-Cap” stocks (the eight stocks that currently represent almost 25% of the market cap of the S&P 500) are trading at near-record valuations relative to the remaining 492 stocks in the index.
As always, we encourage investors to maintain portfolios that cater to their unique investment time horizon and risk profile. In the long-term, a disciplined process which focuses on risk management and diversification leads to superior results.
Despite inflation reports which showed the pace of inflation continues to moderate – both as measured by the Consumer Price Index and the Producer Price Index, markets finished the week lower, weighed down by little progress towards resolving the US debt ceiling. Should congress fail to reach a debt ceiling agreement, the Brookings Institute estimates that the treasury could continue to make interest payments on government debt but would have to cut other outlays by 25%. [1]Lower government spending would slow economic growth and borrowers may require a higher interest rate to lend to the government, thus leading to lower bond prices and lower stock market valuations. Lower asset prices and higher borrowing costs would lower consumer and business confidence. In an economy that many believe may already be on the precipice of recession, failure to reach an agreement would certainly increase recessionary risk. Even if a deal is reached, the economy would not be out of the woods. A deal would likely include spending cuts and act as a tightening of fiscal policy – at a point in time when the Fed has just raised borrowing costs and continues its $95b/month reduction in the size of its balance sheet. Policymakers face a significant challenge – continue fiscal and monetary accommodation to support current growth but risk inflation and lack of progress towards containing ballooning deficits and levels of government debt. Regardless of the outcome, current low levels of market volatility may prove to be overly complacent.
The Consumer Price Index continued to moderate in April yet remains above the Federal Reserve’s 2% mandate. As reflected in the chart above, goods inflation has moderated from the COVID-related supply chain issues, yet services inflation remains high. Core Services inflation will likely continue to moderate (housing and wage growth tend to be leading indicators), yet we believe that it is likely inflation will remain above the level in which the Federal Reserve is likely to cut interest rates.
A very volatile week in markets saw the major indices rally on Friday to finish the week only modestly lower. The week was highlighted by the Federal Reserve decision announcement on Wednesday to hike the federal funds rates by 0.25% to 5.0-5.25%. While the rate increase was largely anticipated, remarks by Fed Chair Powell skewed more hawkish than the market had hoped. Powell signaled to the market that the Fed intends to remain “data dependent” and will keep the flexibility to continue to hike rates should inflation remain high.
As depicted in this week’s Chart of the Week, the market has a very different expectation than the Fed. The current futures pricing reflects a 99.9% probability that the Fed will cut rates at least once by the end of the year and a 97% chance that the Fed will cut by at least two 0.25% decreases. The median expectation is for the Fed to cut by 0.75% by year-end. Consistent with market prognostications are economist forecasts; the Atlanta Fed GDP Now forecasting tool estimates that the economy will grow at a 2.7% pace in Q2, vs economist expectations of no growth.
Market rate-cut expectations and economists’ call for stalling growth paint a stark picture for near-term risk assets. The Federal Reserve has acknowledged that its actions impact the economy through “long and variable lags.” The ongoing bank turmoil and credit crunch may be early indications of building stress in the financial system, however, the Fed has drawn its line in the sand and is messaging that, while a pause may be justified, it has yet to see the case for rate cuts. Moreover, and under-reported in the financial press, the Fed has been unflinching in its ongoing balance sheet reduction. History tells us that “Mr. Market” is usually more prescient than the Fed, but, in our view risks to near-term asset prices are mounting. Investors will be well-served by employing a disciplined approach that is structured around their unique investment time horizon and financial plan.
A busy week for economic data which, on the whole, showed slowing economic growth and moderating inflation pressures pushed equity indices to modest gains. Inflation data, highlighted by the CPI and PPI reports, came in below expectations with the forward-looking PPI report posting its largest month-over-month decline since the start of the pandemic. Meanwhile, data on the health of the US consumer was mixed; retail sales fell 1% for the month of March while sentiment data ticked up (from still low levels).
Also released this week were the minutes from the Federal Reserve March meeting which showed growing concern amongst central bankers that recent banking stress would lead to “a mild recession” later this year. Troubling, however, was that the report also noted inflation remains “unacceptably high” and that the reduction in inflation was progressing with “slower-than-expected progress.” While the Fed may be nearing the end of its rate hiking cycle, it may defy market expectations for rate cuts by year-end absent significant deterioration of the labor market, which continues to hold up reasonably well.
Investors will focus on Q1 earnings next week and will hope that strong momentum continues after a solid beat by JPMorgan.
The tech-heavy NASDAQ index and the Small-Cap Russell 2000 index have deviated in recent weeks, with the NASDAQ significantly outperforming. Markets may be recognizing that smaller companies have a higher reliance on bank financing and the recent banking turmoil has significantly tightened credit conditions. Alternatively, investors may be renewing hopes of another tech-driven run despite high valuations and a higher interest rate/inflationary environment.
Markets had a tough holiday-shortened week. Stock and bond prices fell as bond yields rose, reflecting investors’ adjusted views on a Federal Reserve which may need to maintain a restrictive policy stance in light of stickier inflation and diminished signs of a severe economic downturn. Rates markets reacted to the release of the Fed minutes from the early February meeting which indicated a continued resolve by policy makers to maintain higher short-term borrowing costs in an attempt to cool economic growth and quell inflation. Additionally, a higher-than-expected print of the PCE price indicator, the Fed’s preferred gauge of inflation, pushed short-term rates back to levels approaching 15-year highs.
While we remain aware of the monthly volatility in inflation data, we also note that the larger trend is one of less severe levels of price change. CPI data is up 3.5% at an annual rate over the last three months (down from the 9.1% rate witnessed in June of last year) and monetary policy is now at a level at which deteriorating economic conditions could be met with appropriate policy action. The path to normalization will likely continue to be a rocky one, but we continue to believe in the prudence of a disciplined, long-term approach.
A decade-plus of US stock market outperformance (>200% outperformance of US vs Emerging Mkts stocks, measured in US Dollar) has lead to a dislocation between market capitalization and the share of global GDP. As a percent of market cap, Emerging Mkts represent 13% of global stock market value but 50% of global GDP. As a result, the valuation difference between developed and emerging market stocks are trading at 20-year lows. These trends represent significant opportunity for investors with a long-term time horizon.
Advisory services are offered through Presidio Capital Management LLC, Registered Investment Advisers. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Presidio Capital Management, LLC unless a client service agreement is in place.
Stock markets took a pause last week, posting the biggest five-day losses since mid-December, yet remain broadly positive on the year. The decline was largely due to dampened expectations of a Fed rate cut by year-end as Fed Chair Powell reiterated the committee’s expectations that policy would likely remain tight. As a result, the policy-sensitive 2 year treasury interest rate rose to 4.48%, its highest level since November and at levels close to multi-decade highs.
As we look forward to data for the week of 2/13-2/17, we keep an eye on continued corporate earnings as well as a much anticipated report on inflation due for release on Tuesday. Expectations are for CPI to have increased by 0.5% through the month of January with the year-over-year figure at 6.2% – a decline from the previous month.
Chart of the Week:
Despite high profile recent layoffs, the labor market remains on solid footing relative to pre-pandemic levels.
Advisory services are offered through Presidio Capital Management LLC, Registered Investment Advisers. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Presidio Capital Management, LLC unless a client service agreement is in place.
US Markets rallied this week with all three major indices posting gains on the back of a better-than-expected Q4 ’22 GDP report and corporate earnings. On the economic data front, the initial estimate of 2022 Q4 growth was 2.9%, beating estimates and the PCE price index reported a 5% gain from December ’21 – slightly below expectations and the lowest reading since September 2021. Notable earnings beats on the week included Tesla and American Express. Intel and Chevron missed their respective estimates.
Looking forward, all eyes will be on the Federal Reserve’s meeting next week. It is widely expected that it will announce an increase in the Federal Funds rate of 0.25% to 4.5%-4.75%. The market is currently pricing just a 1.9% chance that the Federal Reserve will increase by 0.5% and a 0% likelihood that the Fed won’t hike at all. This is down from a 40% likelihood of a 0.50% hike at the start of the year, reflecting the broadly lower inflation readings that have been reported in January.
Looking more broadly, the yield on the U.S. 10-year bond peaked on October 24th at 4.25% and has retreated to 3.5%. This decrease in yields has boosted the price of both bonds and stocks with cyclical assets, such as Emerging Market stocks, European Stocks and US Small-Cap/Mid-Cap and Value outperforming the broad market. Markets will pay close attention to the Federal Reserve next week for their cue on whether this rally can continue with a more acquiescent Fed, or if Jerome Powell & co will maintain the position that rates will remain high for some time.
A strong January (5%+ return) after a negative year has historically been positive for full-year S&P 500 performance, with the market positive in each of the last five instances and an average return of almost 30% for the year.
Advisory services are offered through Presidio Capital Management LLC, Registered Investment Advisers. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Presidio Capital Management, LLC unless a client service agreement is in place.
Fed Governor Powell gave a speech on Wednesday laying out the current challenges in bringing inflation back down towards its 2% “ish” target (1). In general, the tone of the speech was hawkish (see the link below if you want to read it). However hawkish he appeared for the bulk of the speech, traders reacted very positively to his closing paragraph. Mr. Powell mentioned that given the full effects of the rapid increases in interest rates are yet to be felt in the economy. It was this sentence that got traders racing to press the buy button. “It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down”.
The Nasdaq Composite rose nearly 5% on Wednesday alone. It kind of shows you how the market is desperate for some comfort that rate hikes are coming to an end. It wasn’t only the US equity markets that reacted positively. Credit Markets, specifically longer maturity bonds rallied, with the yield on the 10-year US treasury note dropping below 3.5%. It was over 4.2% less than a month ago. That may not seem like a lot, but it is. With that, the US dollar weakened, and international equities responded positively.
The employment data released Friday kind of confirmed what the Fed was saying about the full effects of rate increases still not fully reflected in the economy. Economists were predicting 200,000 jobs added for November. It came in at 263,000, signaling a pretty resilient labor market. (2)
Yet, on the corporate earnings side, analysts are sharpening their pencils and reducing their earnings targets for corporate America in Q4. According to FactSet, analysts have lowered their Q4 earnings for the S&P 500 by 5.6%. Historically, the average decline is around 2.1%. This decline was larger than the 5-year, 10-year, 15-year and 20-year average. Only two sectors had positive earnings growth estimates, with energy leading the way. (3)
What does this all mean? First and foremost, the economy is slowing. Inflation is lasting longer and straining household budgets. The stock market is not pricing in a recession. Economists are still all over the spectrum. Some see a recession coming in 2023 while others see the economy “just missing” a recession. Regardless, when earnings decline so do the multiples investors are willing to pay for those earnings. Investors love to pay high multiples for growing earnings. They pay less for slowing earnings, and even less for declining earnings. The weighted average forward (i.e., 2023) Price to Earnings multiple on the S&P 500 is around 17 times. If earnings start to really come down, the multiple could easily approach 15, if not lower. That could mean a tough year ahead for the markets, despite already enduring a tough time this year.
Chinese Protests Take a Bite out of Apple’s Stock Price:
China is still battling Covid-19. Lockdowns are still in place in many parts of the country. People are tired of it. Many have taken to the streets to protest the never-ending lockdowns. Apple relies on China for a large portion of their iPhone production. Q4 shipments could be down close to 15 million units. Some analysts have even mentioned the unthinkable; a potential revenue decline in 2023. Granted, Apple has had slight revenue declines in the recent past, but the stock wasn’t as richly priced as it is today. It currently trades for 24 times earnings. A pretty rich premium to the S&P. This premium has been warranted in the past. You can even argue that it may have been valued too cheaply in 2015. Apple is a large component of all three of the major US indices. It is owned and loved by many analysts and individuals. It has made many people very wealthy. Apple’s market cap is $2.35 trillion now. It was valued at nearly $3 trillion in early January. In January of 2106, it had a paltry (sarcasm noted) market cap of $570 billion. That is a ton of wealth creation. It’s been the largest component of the S&P 500 since 2011! That is a long time. Before that, Exxon Mobil was the largest, and held that post from 2005 until Apple took over the top spot.
We have been conditioned to believe that Apple will always be “Apple”. No company has every dominated corporate America indefinitely. Zero! The iPhone launched in 2006 when Apple had a market cap of roughly $60 billion. Since that launch, Apple remained a product innovative juggernaut. The new Mac laptop, the iPad, the Apple watch. All amazing products that have changed lives. That pace of innovation is likely finite. Apple will likely remain one of the larger Corporations in America for a while, but don’t expect the same share price growth that we’ve witnessed over the past 15 years.
Advisory services are offered through Presidio Capital Management LLC, Registered Investment Advisers. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Presidio Capital Management, LLC unless a client service agreement is in place.
