Thought to ponder…
“While I am not sure what my focus on truncating downside risk has cost me over time in terms of lost opportunity, I am certain that I have not maximized return. But at least I can be sure that I will be around for future opportunities.“
- Steven Drobny, The Invisible Hands
The View From 30,000 Feet
It’s been six weeks since the collapse of Silicon Valley Bank. Since then, the markets have gone from panicking over the prospects of a systemic banking crisis, fear of an imminent recession and expectations for the Fed to cut rates immediately, to coming around to the Fed’s view of one more rate hike and no rate cuts till late 2023 / early 2024, buying into the story of immaculate disinflation (disinflation with limited negative impact to employment and growth) and a soft-landing. The relative quiet from the SVB storm has opened the door for focus on other topics, such as earnings, the debt ceiling debate, and economic data that provides a murky picture of a slowing economy with persistent pockets of strength, driving continued vigilance from the Fed.
- 2023 S&P500 earning projections diverging from Fed Fund policy projections
- The debt ceiling debate re-enters the spotlight as Speaker McCarthy puts forward his wish list
- What a softening employment market looks like in the context of prior Unemployment cycles
- The most Frequently Asked Question from client’s this week: Should you be worried about the fearmongering forecasters who keep pointing to the Conference Board’s Leading Economic Indicators?
2023 S&P 500 Earning Projections Diverging from Fed Policy Projections
According to Factset’s aggregation of analyst estimates, earnings are expected to trough in Q1 2023 and then begin to climb the remainder of the year.
According to Fed Funds Futures, the Fed Funds rate is expected to peak in Q2 2023, remain steady until November and then begin to fall late in 2023.
These two assumptions are run opposite of one anoter. If the economy is forecast to fall into a recession in the second half of 2023, prompting the Fed to cut rates, earnings will not be increasing. Earnings do not increase during a recession when the economy is contracting, they fall.
Another way to think about it is, if the Fed is cutting rates, why are they cutting rates? They are cutting rates because:
- There is an issue with financial stability
- They are concerned about disinflationary forces
- They are worried about economic growth (sustaining full employment)
None of these three factors are consistent with rising earnings.
Bottom Line: Either you believe the Fed will cut rates because of a weakening economy or you believe earnings will move higher because of economic strength, but you can’t believe both.
Market Expectations of Earnings Growth Doesn't Align With Falling Fed Forecasts
The Debt Ceiling Debate, Speaker McCarthy Puts Forward his Wish List
Speaker McCarthy put forward the first proposal for solving the debt ceiling problem that was promptly rejected by the White House, in what is expected to be a drama between members of Congress and the Administration that concludes in July. The debate centers around two major issues: Raising the Ceiling and Controlling Spending.
- The debt ceiling debate began three months early because McCarthy and markets are concerned that tax receipts from April and June payments will be insufficient to provide the government the capital they need to operate until mid-summer.
McCarthy proposal is to increase debt ceiling by 5t and reduce budget by 4.5t, (10-years) reductions include:
Bottom Line: There’s no scenario where the debt ceiling problem does not get solved. The ceiling will be raised, the questions are which programs will be cut and if McCarthy can influence a spending It looks like the ultimate deadline to finish negotiations will be mid-July. The most recent memorable debt ceiling standoff was in 2011, when on August 5, 2011, Standard & Poors downgraded US Sovereign Debt. During that episode, CDS on US 5yr Debt traded over 60 bps and the S&P500 fell over 16%. On course to out do 2011, CDS on US 5yr broke through 54 bps on Friday, the highest level since 2011. Keep in mind, the economy was careening towards a recession in the summer of 2011, which was abated when Bernanke gave a Jackson’s Hole speech at the end of August promising a fresh round of QE.
As Debt Ceiling Showdown Intensifies Growth Set to Outperform Value
What a Softening Employment Market Looks Like
In the last 50 years there have been 6 unemployment cycles. Excluding the pandemic, the data is remarkably consistent across unemployment cycles.
- Average increase in unemployment: 2% from beginning level
- Average time from trough to peak in unemployment: 36 months
Bottom Line: According the Fed’s Summary of Economic Projections, unemployment will rise from 3.5% to 6% in 2023 and hold there in 2024 before beginning to fall in 2025. If this were to happen it would be the first time in the last 50 years that unemployment would only rise 1.1%. Historically, once unemployment begins to rise it keeps going well beyond 1%. Each of the employment cycles over the last 50 years has been associated with a recession. On average, by the time unemployment rose 0.4% the economy was in recession, and unemployment continued to rise another 3.8% thereafter before peaking.
Labor Market Strong, but Weakening at the Margins
Should You Be Worried About the Forecasters Who Point to the LEI?
Bottom Line (Top Line) – Yes, you should be worried. There is very little argument among strategists that there is a recession coming. The question is, when it will arrive? If you’re willing to concede there is a recession coming in the next 12 months, you have to ask yourself, do you believe you can squeeze the last little bits of juice out of the markets before tactically timing the top, or is it better to reduce risk in advance, clip a fat coupon in Treasuries, and wait out the storm? (refer back to Thought to Ponder beginning of this week’s piece).
The Conference Board’s Leading Economic Indicators is made up of 10 different indicators, with about 85% of the weight divided among employment, new orders, the yield curve and consumer sentiment.
Dating back to 1960, when the year-over-year change was less than -5.0 the economy enters a recession 100% of the The LEI is currently at -7.8, breaching the important -5.0 level at the end of January.
There is no one perfect indicator. Focus Point has its own leading market indicator that uses 28 indicators, divided among Liquidity, Valuation, Economic Momentum Technical and Volatility. The Focus Point Leading Market Indicator, began flashing warnings signals when it entered negative conditions in April of 2022.
Pick your poison, whether you believe in the Conference Board’s Leading Economic Indicators or Focus Point’s Leading Market Indicator, or the host of dozens of other indicators that are flashing warning signals, if you are trying to eek out the last incremental gains before the recession, you are picking up nickels in front of a steam You may be right for a while, but the probability is that you’re going to get flattened.
Conference Board Leading Economic Indicator – Weightings and Forecasting Track Record 100%
Putting It All Together
As concerns about a systemic crisis in the banking system fade, attention has shifted to earnings, economic indicators that are perceived to drive the Fed’s coming course of action and a brewing storm forming around the debt ceiling debate.
Our Three-Legged Stool thesis of strength in the labor market, strong Balance Sheets (excess cash reserves) and persistently strong earnings, continues to prop up the equity markets. Although there is still strength in each of these legs, the weight on the stool is crushing, with indicator after indicator predicting that the legs will eventually break.
This is a fascinating set up because the Three-Legged Stool strength is providing a basis for an already expensive market to continue higher, but with so many indicators and the Fed all forecasting a recession, having equity exposure feels like picking up nickels in front of a steam roller because the probability is that the stool will eventually break.
Circling back to the quote at the beginning of this week’s piece. If your objective is to maximize return, playing the momentum of the markets may be reasonable, but if the indicators are correct, risk exposure should be very tactical because when the stool breaks the downside is likely significantly deeper than the upside from current valuations. Even a shallow recession has historically meant earnings reductions in the range of 20% and trough P/E’s significantly lower than today’s values.
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