A Nudge in the Fed’s Direction

With 92% of the S&P500 having reported, the earnings season is in the bag. The Bottom Line: Q1 2023 had the highest percent of companies beating earnings since Q3 2021, signaling analysts had become too pessimistic. Normally, companies rally when their actuals exceed estimates. This was not the experience in Q1 2023, those companies who beat showed only marginal gains, while those that missed were taken to the woodshed, perhaps a sign that investors are nervous and not adding to winners but selling losers. With earnings season in the rearview mirror, all eyes will be turning to the economy/inflation, the debt ceiling debate, banking turmoil and geopolitics. Historically, during the relative quiet following earnings season the markets gravitate in the direction of the underlying trend, which today is a weak upward bias towards resistance levels with a lot of chop. To help matters, incremental positive signs for inflation and a potential resolution for the debt ceiling debate stand to act as positive catalysts in the coming weeks.

• At the margin, the Fed saw what they were hoping for last week from the real economy, signs of moderating inflation and a less pressurized labor market
• A heavy week of survey data included the University of Michigan, NFIB and Senior Loan Officers Opinion Survey telling the same message: Deteriorating sentiment
• Cyclical versus Secular trends in commodities – short-term growth concerns juxtaposed against long-term supply constraints
• The most Frequently Asked Question from client’s this week: What are some of the upside surprises and downside risks the market is not accounting for?

CPI: Still too high for comfort but signs of moderation

• The Big Three – Things that everyone has to contend with: Food, Shelter and Energy
• Food At Home: Has been negative for the last two months.
• Shelter: The long-awaited flow through from falling housing and lease rates is beginning to be picked up in calculations though recent data suggesting a firming in residential real estate, threatening to stall the trend.
  Energy: Weak petroleum and natural gas prices tied to demand concerns pressuring prices down double digits in last 12 months.
• Services ex-Shelter (Supercore): Showing the first meaningful signs of deceleration.
  PPI: Downward trend for wholesale should follow through to CPI in coming quarter
• Completed round trip back to Fed’s comfort level with YoY increase now being held to 3% and still falling.
• PPI has been leading CPI since pandemic by about three to four months, pointing to material weakening in CPI by the fall.
  Employment: Leading indicators continuing to show softening
• Initial Jobless Claims and Continuing Jobless Claims continue upwards trends. Taken in conjunction with to upticks in WARN notices (large layoff filings), trends in Overtime and Temp worker demand and downtrend in JOLTS data, signal a softening in the labor markets.

Bottomline: It’s important to not get fixated on one week or one month of data, which can be noisy and subject to idiosyncratic issues and data abnormalities (for example, last weeks questionable Massachusetts claims numbers that influenced a much higher than expected Initial Claims number), rather focus on trends. The Fed has laid out a path to a pause and an eventual lowering of rates, which is continued downward readings of inflation with confidence that PCE is headed towards 2%. Key to this path is consistently lower readings on inflation and a softening of the labor market. At the margin, that’s exactly what we saw in the numbers last week.

University of Michigan:

• Initial data from the survey showed sentiment, views of economic conditions and consumer expectations all tumbling lower, while long- term expectations for inflation moved higher.
• This is a mixed bag, while signs of lower sentiment is welcome news to the Fed because it indicates subdued demand, it’s concerning that long-term inflation expectations is increasing because the unmooring of long-term inflation expectations signals that attitudes about inflation are at risk of becoming embedded in the economy, which make inflation sticky and harder to wring out of the system.

NFIB Small Business Survey:

• The Survey continued to slide lower, falling well below levels seen during the pandemic, with only the GFC and the recession of the early 1980’s showing eras of worse small business sentiment.
• The headline from the report was the handoff from the largest concern being inflation to that of qualified labor. We’d contend this is really the same issue, as highlighted by the Fed, who continues to drive home the point that until the labor market softens, inflationary pressures will be hard to subdue because labor is a large component of inflation.

Senior Loan Officer Survey:

• The big takeaway from the Survey was the both supply and demand of credit is falling, which was to be expect. Perhaps the only real surprise was the fall in demand was actually larger than the fall in supply, signaling that companies are slowing the willingness to expand in the face of the perceived deterioration in the economy.
• Fall in supply and demand for credit has historically had a high correlation with corporate defaults, suggesting the corporate defaults could rise by as much as 4x over the next year, and bring with it a long-awaited credit cycle that’s been looming.

Bottomline:

There were a lot of data points on sentiment last week. The overall conclusion is that sentiment is softening across the board, with worries about inflation, the labor market, the political wranglings in Washington and banking crisis taking their toll on consumers and companies, which together should add up to slowing force on the economy.

Mixed bag for the Fed with rising inflation expectations, but sharp fall of in credit supply and demand

Cyclical Story

• Recession worries, underwhelming re-opening in China and Europe’s good luck with winter weather and success in curtailing energy demand driving weak demand and lower prices in the short-term.
• OPEC+ cut production targets by 500k barrels a day on April 2nd based on their view of deteriorating demand, since then the price of WTI Oil has dropped -12.9%, signaling that OPEC+ may be correct to be worried about reduced demand.
• Copper (the commodity with the PhD – because it so smart) and Iron Ore are both in deep downtrends, signaling weak industrial demand.
• China PMI and Caixin have both fallen back into contraction territory, after briefly spiking into expansionary levels after the re- opening announcements.
• After peaking in January, German, France and Italy have all resumed a downward trend in manufacturing PMIs. Spain and the United Kingdom peaked shortly after and have also begun moving lower.
• German Industrial Manufacturing Orders cratered -10.7% last month, something previously only seen in recessions.

Secular Story

• Projected demand from the shift to renewables, under investment, higher financing costs and long lead times to develop reserves creating an environment for chronic shortages and upward bias to pricing.
• Regulatory challenges make brining demand online a task measured in decades.

“It’s taking an average of 23 years from discovery of a copper resource to a producing mine”

- Airguide

Upside Surprises:

• Cash yield from Money Market Funds
• Assets are being drawn to Money Market Fund because they have a compelling In fact, Money Market Funds interest payments to investors are now contributing an annualized run rate of over 1% of GDP ($250b).
• Broadening out of the rally
• The story that only 7 stocks have accounted for 90% of the gain of the S&P500 this year is well If earnings continue to surprise to the upside, the group of winners will broaden out.
• Structural employment challenges keeping demand for workers persistently .
• Prime age worker labor participation has surpassed pre-pandemic trends, signaling there is little additional slack in the labor market, and may support Fed’s view that they can slow the economy without materially impacting the labor market.
• Wages are rising faster than goods prices providing consumers with excess spending power to support consumption.

Downside Risks

• Debt Ceiling Resolution
• Progress on the debt ceiling could lead to a short-term relief rally based on the removal of default risk to be followed by long-term reckoning tied to removal of liquidity and austerity.
• The bull case is predicated on continued moderation in inflation, however, this falls in the category of careful what you wish for. If deflation takes hold, nominal sales will fall at the same time margins are falling which will lead to a rapid deceleration in earnings.
• Signals from the commodities markets
• Oil, Copper, iron Ore are experiencing deep selloffs, signaling a weakening in the industrial complex, corroborated by Manufacturing PMIs deteriorating into contraction territory in the three largest economic zones in the world.
• Equity markets are priced for perfection, discounting lower rates in the summer / fall, with accelerating
• There is a blatant contradiction: Expecting lower rates and higher earnings. The Fed cuts rates for one of three reasons: financial stability concerns, deflationary pressures, growth concerns… any of these developments would be bad for equity prices.

The inflation debate is stuck in a point versus counter-point debate. Each week we are presented with evidence that inflationary pressures are easing as well as reasons to believe inflation will be sticky. Pick your poison.

• Disinflation Points
• Falling goods prices
• Falling commodity prices
• Cooling labor market
• Turmoil in commercial real estate market, and dramatic slowdown in residential real estate market
• Fractured banking system with evaporating credit supply and demand
• Recessionary sentiment from consumers and businesses

• Inflationary Counter Points
• Persistently strong labor demand and wage growth
• Measures of inflation that are “sticky” remain elevated
• Evidence of inflation expectations becoming unmoored
• Unyielding consumer spending
• Continued strength in corporate earnings
• Signs that housing market has stabilized and pricings beginning to move higher

The Fed has indicated that they will persist with a hawkish bias until it’s clear that the Inflationary Counter Points begin to fade. The challenge with proceeding along this path it’s uncertain how long it will take for the Inflationary Counter Points lose momentum, meanwhile, the Disinflationary Points are gaining momentum like a hurricane, threatening to move from a Category 2 storm to a Category 4 storm.

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