“Beware the Ides of March.” – Shakespeare, Julius Caesar
Consumer and Inflation
The wild government spending spree that some continue to say was not inflationary continues to show up in the data. The chart below shows the SPIKE in the level of household saving over disposable income. Despite a large decline, to the tune of $1 trillion from the peak levels just over a year ago, excess savings remains at more than $1.5 trillion above levels before the excess spending.
So while Americans love to spend and have done their share of that, until these balances decline further, inflation will have a tough time getting back to 2%. The notion that spending wasn’t the cause, and isn’t inflationary is once again shown to be a false narrative. It was also unrealistic to expect inflation to decline in a straight line, and some are just now waking up to that fact. The economic cheerleaders say these excess savings are what is also keeping the economy from deteriorating faster. Well, from where I sit that’s not so positive when we consider it makes the Fed’s job tougher and keeps them in the picture longer.
With consumer prices, producer prices, and the Fed’s gauge of personal consumption all surprising to the upside last month, the stock market has had to undergo a “reset”. The ‘forecasts’ were now indicating roughly three more 25-basis-point hikes this year with the possibility of a 50-basis-point move next week. That gets us to the terminal rate of nearly 5.75%, with an increasing discussion of that flaring up to 6+%. This should finally dash the “dream” that the Fed was going to cut rates in ’23. A notion that seemed to be more cheerleading and financial irresponsibility than anything else.
The message here hasn’t changed since mid ’22 and it has been
“Higher for longer” as inflation will remain “sticky”.
During this Bear market, I’ve often highlighted how fiscal policy has made the Fed’s job more challenging. Unless we start to see a change that produces assistance to fight inflation (fiscal responsibility), the ingredients are in place to produce a much more hawkish rate scene than anyone wants to believe.
The two-year US Treasury yield hit its highest level in 15 years. Last October when the two-year rate approached its peak below the current level last fall, the S&P 500 Index hit a bear market closing low of 3577.
Fast forward to today, with More uncertainty and lower earnings expectations, the S&P trades at 3940. It’s a clear signal that markets do indeed have a mind of their own and their movements at times are All based on Emotion. How an investor answers the question on the outlook for the rest of the year will play into these emotional swings. Have we seen the worst? Are things going to get better? Or are they about to get worse? The stock market continues to bounce between the glass-half-full and the glass-half-empty viewpoints.
Glass Half Full/Glass Half Empty
For many, valuations have ceased to be critical, as the answer to one of those questions is things aren’t so bad and they will get better. For now, it’s the glass-half-full stage. The “things are getting better” playbook is all about Chinese stimulus as they re-open and investment supporting industrial activity. While that is a positive for the Chinese economy, I’m questioning just how much it will impact the situation here in the US. PMI and industrial data here in the US remain in contraction. There is a very good chance the China story will not re-accelerate the current PMI downcycle, and we will watch it extend.
If we dig into the details, much of the stimulus enacted in China has been domestic and consumption-oriented—a key departure from prior cycles when the investment was focused on capital expenditures and heavy industry. As such, the transmission mechanism between Chinese fiscal spending and the global industrial economy may be less impactful. Additionally, we can’t dismiss the current macroeconomic backdrop which is characterized by elevated inflation and Fed tightening.
In 2021, I warned about the government spending that would ignite inflation, and bring the FED into the picture specifically to fight inflation. That is a recipe for economic turmoil and a toxic backdrop, and that is what we have. So until there is a change in the data, let’s not sugarcoat what has been presented thus far. Inflation has to be characterized as “stickier” in this cycle.
Core inflation rose in January and the February report released this week showed the same. Do we need any more evidence as to why the Fed is talking more hawkish now? What is more concerning is the fact that irresponsible mismanagement seen in the California Banking fiasco might dictate a change in Fed policy. The claims that “something broke” needs to be directed to the institutions that failed to manage the risk in their portfolios, not the Fed. I believe that the Fed will successfully bring inflation down over the next year, but clear and convincing progress is also likely to take time and come with economic weakness. Of course, slowing the rate of growth in spending and reducing the rate of growth in debt accumulation would go a long way in making the path easier for the Fed.
History has shown when the Fed has been raising rates to counter inflation and economic growth has been slowing, PMI downcycles have been longer and deeper, and that environment has often been accompanied by an inverted yield curve. That is exactly what we have today and it’s why I’m not so confident the good news for China’s economy will relate to good news for the US economy.
Remember what I’ve said many times in this Bear market, we have NEVER been here before. For starters, we saw unprecedented stimulus, followed by an unprecedented rate hiking cycle. That leaves it impossible for anyone to use historical norms to form a conclusion on how this is going to play out.
The economy will have to contend with structural labor market changes that are present. There are an overwhelming amount of job opportunities while the labor participation rate still sits near historic lows. Roughly one in nine men ages 25 to 54, an individual’s prime working years, are out of the labor market today; that compared to one in 50 in the mid-1950s. This is a chilling statistic that exemplifies a structural change that is apt to have major ramifications for the economy.
We are also witnessing shifting dynamics around deglobalization, and geopolitics. Last week we discussed how decarbonization will also play a huge role in the years to come, and how investors can take advantage of that sea change. These issues present the probability of a fundamental regime change in inflation as well. The implications then are for a higher terminal rate in this cycle and over time a higher Fed neutral rate.
TWEAKING PORTFOLIOS to keep up with the changing MACRO environment.
All of this will reshape what an investor’s optimal investment portfolio will look like. It will be a much different basket of assets than what we saw from the end of the financial crisis to February 2021. We have already seen the first step in this transformation take root. The New Era investment theme that was introduced in February ’22 was not only correct, but it served as the outline of how investors need to be positioned in this macroeconomic scene. As with any strategy, there will be times when minor changes will be required along the way, and it has been an ongoing process, with more “tweaking” taking place in the last few months. Adding CD ladders, stocks in the Defense sector, Minerals, Mining, Agribusiness, and staying with what has been working – Energy.
The global interest rate reset higher last year, while painful, has altered the investment landscape for investors. Sharply higher interest rates have meant that investors no longer need to take outsized risks to generate reasonable returns from their bond allocations.
After a historically poor year for bonds, fixed income now offers favorable valuations in absolute terms and on a relative basis versus other asset classes. This has led to renewed interest in the asset class, particularly now that the yield on the Bloomberg US Aggregate Bond Index generates over 3.0% excess income over the S&P 500’s dividend yield. This attractive risk/reward profile is another change that needs to be incorporated into an investor’s strategy now.
One of those “tweaks” is the result of the geopolitical situation. Sadly, we recently marked the first anniversary of Russia’s war with Ukraine. We can hope, but right now there seems to be no end in sight to the conflict. Neither side has been willing to negotiate or make concessions. As we enter the next phase of the war, whether it ends in months or lingers for years, the geopolitical landscape has shifted. The world’s “peace dividend” was upended when Russia invaded.
Now, for the first time in decades, defense budgets, which had been cut to the bare minimum, are on the rise. Depleting stockpiles of US armaments will have to be replenished. European governments have similarly ramped up their defense spending, and India plans to boost defense spending by 13%. The desire of nations to enhance their military preparedness and replenish the military equipment and artillery sent to Ukraine should continue to support the aerospace and defense industries. While the general market struggles the Aerospace and Defense ETF (ITA) recently made a new high.
We can expect this trend to be part of the landscape for quite some time and it’s another subtle change that needs to be included in the makeup of an investor’s portfolio.
All investment strategies entail the challenge of preserving and accumulating wealth. These are challenging times. The economic regime of the last few years has been characterized by tepid growth, low inflation, and a low-interest rate backdrop. In relative terms, higher interest rates and even higher inflation is the case today, all set in a higher tax anti-business backdrop. That is the recipe for disaster that I warned about since late ’21. When that change became reality it kicked off the New ERA strategy announced in February 2021. It was no coincidence it was also the start of this Bear market.
Choosing the best mix of asset classes to target one’s desired level of risk given time horizon and liquidity requirements is the most meaningful step an investor takes to address this challenge. The biggest challenge today is assessing how the future will look with a long period of elevated interest rates and above-normal inflation. Given the present MACRO environment, we must give that scene a better-than-even probability of occurring.
We’ll change that view only when that scene changes.
The Week On Wall Street
Investors entered into a week that was littered with headline risk. First, a CPI report on Tuesday, followed by the PPI data on Wednesday. The California bank fiasco kept the flight to safety in vogue as treasuries were in demand sending rates lower. The 2-year Treasury traded at 5.06% on March 8th and closed at 4.03% on Monday. In the fixed-income world that is a huge move that usually takes months, now we see this occur in days. It should give everyone a sense of how volatile the entire situation is. During this banking fiasco, I suspect a lot of money was taken out of banks and sent over to treasuries.
Another choppy and volatile session with indices bouncing between gains and losses that were eventually resolved to the downside. Rallies were sold as I suspect most traders weren’t inclined to head into tomorrow’s CPI report with overexposure to equities. The major indices hugged the flatline and posted modest losses except for the NASDAQ which eked out a tiny gain. Eight of the eleven sectors were higher on the day with Energy (XLE) (-2%) and Financials (XLF) (-3.9%) being the biggest losers.
Tuesday was back to a “Glass Half-Full” mentality as fears over the banking issues dissipated. All of the major indices rallied and every sector was higher on the day. That all came tumbling down on Wednesday. The reason was the issues at Credit Suisse, but the catalyst may have been a failure for the S&P to overtake a key resistance level. In that case, investors didn’t need much convincing to Sell first and ask questions later. The result was a waterfall decline.
Rates are down, and the notion that the Fed may pause is moving money into the NASDAQ as the index gained ~4% this week. Despite the overhang of the financial situation, the S&P surprised many by posting a gain of 1.5%. However, that was well off its weekly highs.
This week’s headlines; Manufacturing is in the doldrums, better news on inflation, and February Retails sales fell slightly after a strong January print. Housing perks up. Leading economic indicators and consumer sentiment is aligned with a recession.
The NFIB Small Business report indicated that about half of the small businesses have jobs they can’t fill.
NFIB Chief Economist Bill Dunkelberg;
“The small business labor demand remained strong in February. Small business owners are working to maintain competitive compensation and are raising compensation in the hopes of filling their open critical positions.”
The February CPI report came in about what analysts expected and if one considers it a message that says inflation isn’t getting worse, it’s a win. However, Inflation is still high and a problem for the Fed.
(M/M) Feb: 0.4% (est. 0.4%; prev. 0.5%)(Y/Y) Feb: 6.0% (est. 6.0%; prev. 6.4%)Core (M/M) Feb: 0.5% (est. 0.4%; prev. 0.4%)Core (Y/Y) Feb: 5.5% (est. 5.5%; prev. 5.6%)
February PPI (Producer Price Index) dipped -0.1% and the core was unchanged, weaker than expected. The annual rates for February slowed to 4.6% year over year and 4.4% y/y, from January rates of 5.7% y/y and 5.0% y/y. February retail sales fell -0.4% overall and slipped -0.1% excluding autos. Sales climbed 3.2% and 2.4%, respectively, in January.
Excluding autos, gas, and building materials, sales are unchanged following the 2.9% surge in December.
The Empire State manufacturing index dropped 18.8 points to -24.6 in March, well below expectations, after bouncing 27.1 points to -5.8 in February. It is the fourth straight month in contraction.
Declines were broad-based with most of the components in contractionary territory.
The Philly Fed index remains depressed at -23.2 in March from a 2-year low of -24.3 in the prior month. The components were weaker than the headline, and the ISM-adjusted Philly Fed plunged to a 3-year low of 39.5 from 49.8, leaving that gauge well below the prior low of 46.3 in December.
This week’s weak Philly Fed and component data accompany big declines for both the headline and component Empire State figures extending the 16-month pullback from robust peaks for most sentiment measures in November of 2021. Most of the various component categories across surveys are in contraction territory.
Housing starts rebounded 9.8% to 1.45 million in February, stronger than expected. They declined 2.0% to 1.32 million in January. Before the February bounce, starts had dropped for five straight months to a three-year low.
Consumer Confidence Leading Economic indicators continue to portray a weak economic scene.
The preliminary Michigan sentiment report revealed a headline drop to a 3-month low of 63.4 in March from a 14-month high of 67.0 in February, with 3-month lows for both current conditions and expectations. Michigan sentiment is oscillating below the early pandemic bottom of 71.8 in April 2020, but above the all-time low of 50.0 in June 2022.
Confidence remains modestly above mid-2022 troughs, but well below mid-2021 peaks. All the surveys face headwinds from elevated mortgage rates, ongoing recession fears, and now bank failures
The leading index fell another 0.3% to 110.0 in February after slipping 0.3% to 110.6 in January. This is the 11th consecutive monthly drop, the longest since the 24-month slide in 2008-09. It is the lowest since February 2021 (and compares to an all-time nadir of 25.9 from 1959). The 10 components were split with six negative contributors.
The Global Scene
The ECB raises three key interest rates by 50 basis points. The ECB;
“Inflation is projected to remain too high for too long. Therefore, the Governing Council today decided to increase the three key ECB interest rates by 50 basis points, in line with its determination to ensure the timely return of inflation to the 2% medium-term target. The elevated level of uncertainty reinforces the importance of a data-dependent approach to the Governing Council’s policy rate decisions, which will be determined by its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.
The Governing Council is monitoring current market tensions closely and stands ready to respond as necessary to preserve price stability and financial stability in the euro area. The euro area banking sector is resilient, with strong capital and liquidity positions. In any case, the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy.”
That move may have set the tone for the FED to raise rates at the FOMC meeting next week, as inflation remains the main concern.
Since the week of February 23rd, optimism has been muted with less than a quarter of respondents to the weekly AAII sentiment survey reporting as bullish. That includes a new low of 19.2% set this week. That is the least optimistic reading on sentiment since September of last year.
The drop in bullishness was met with a corresponding jump in bearish sentiment. That reading climbed from 41.7% up to 48.4%, the highest level since the week of December 22nd. While close to half of respondents are reporting as bearish, that remains well below the much higher readings that eclipsed 60% last year.
The Daily chart of the S&P 500 (SPY)
Monday it appeared the Chart of the S&P 500 was on the verge of breaking down. By Thursday it was a much-improved picture, but the Bears seized control of the last day of trading and for the most part, wiped out Thursday’s gains.
Another week with quick moves where everyone gets enamored by the price action only to see it change on a dime. The onus is on the Bulls as Thursday’s and Friday’s price action sure looks like another failed attempt to take out the resistance levels.
We can’t predict the future, but we sure can use probabilities to increase our odds of success. I can’t tell you if this Bear market will wind up with the same results seen in 2000 or 2008. I do know the S&P is 19% off the all-time high and it’s been in the Bear market trend since it closed below Long term support in April ’22. Looking at the short-term, and more importantly, the Long term index charts, Bear trends dominate. I’m amazed how some have already said and continue to say this is a new Bull market.
Uncertainty was already high and in the last week or so it’s ramped up to another level. Inflation is still a Big question mark. Now the talk is the Fed may or may not raise interest rates next week because they are concerned about a bank failure. A debacle that in reality was caused by irresponsible management, failed oversight by the regulators, and NOTHING else.
Investors are so focused on CPI, PPI, and PCE reports, every Fed word that is spoken, and every employment report to see if the economy is slowing or accelerating, it makes for a scene where “headline” risk is at extremes. This market has been difficult to navigate because the swings are quick and violent, and for the most part, they are all coming after a headline event.
Therein lies the very short-term risk to both the upside and downside. The indices and select sectors are up against resistance, and we’ll get a better idea of what comes next in a few days. The Primary trend is Bearish and that is the primary trend to follow in making decisions now.
If you were wondering why I’ve said there is uncertainty and confusion around now, all you have to do is look at the conflicting messages the market has given us in the last few days as an example.
Interest rates have plummeted, as the flight to safety trade is in full bloom over the banking events and a global slowdown. Crude Oil and the entire commodity complex have cratered on global recession fears. Precious metals and Bitcoin are now seen as safe havens on the same premise. At the same time, semiconductors are acting like we are on the doorstep of a booming economy. While I realize technology is always in sync with a lower 10-year Treasury yield, this looks like an overshoot bordering on an extreme.
The 10-year has indeed fallen from 4.08% to 3.45 in 11 trading days, but the last time the 10-year treasury was at 3.5% the Semiconductor index (SOXX) was at $380. Friday the 10-year Treasury closed at 3.5% and the SOXX closed at $427. In that same time frame, the NASDAQ has rallied 12%. None of this is meant to be taken as “actionable” advice, it’s just another example of how difficult it is to gauge anything these days.
With the Fed still raising rates, it would appear the move into Technology and the Semis, in particular, wouldn’t have much-staying power, but I’m hard-pressed to deny what is happening in front of our eyes. We’ll know soon enough. Perhaps this latest move is all in anticipation of a “pause” in the rate hikes next week. An idea that seems to be gaining more traction and feeding this move.
The other group that has rallied sharply (+4.3% in 3 days) is Communications Services. That sector combined with Technology makes up 35% of the S&P 500, and it’s a reason why the S&P has stayed resilient lately.
No need to go into too much detail this week on the sectors. Suffice it to say the only group in a long-term Bull market trend is Energy (XLE), and that is being tested now. This past week the ETF fell below short-term support and that is a situation that has to be watched in the days ahead. The lone haven is now under stress.
One other sub-sector, Aerospace and Defense (ITA) continue to post strong results. That is the reason this group is now part of the New ERA Investment strategy.
At its year-to-date high back on February 7th, the S&P Financial sector ETF (XLF) was up more than 8% on the year. Since that high, the sector has fallen more than 13% and is now down more than 6% YTD. Ironically many analysts were citing the group as one of the “value” plays for ’23.
Unfortunately, the group never was able to break thru the Longer-term resistance and remains locked in a Bear market trend. It is THE reason I rarely start to move money into a sector before the trend has decidedly changed from negative to positive.
Surprisingly the Semiconductor ETF (SOXX) is on the cusp of breaking its longer-term Bear trend. No doubt the group was hammered last year and was sold to extremes it overshot to the downside. It appears the opposite is occurring today as this sector is suggesting the global economy is robust. We are going to soon find out if this excessive move has run its course.
In February 2022, I believed that we had entered a new era of investing. Without rehashing all of the details here, it stated the “Buy the Dip” era was over and it was a more “sell the rallies” type of market. In addition, it was deemed that only select areas of the market were investable. Technology was reduced to an underweight position and it was time to reduce exposure and raise cash in preparation for what could be a difficult period ahead. That difficult period came to pass with the S&P establishing its Bear market low last October which was ~25% off the highs. The strategy paid off and with Technology the worst-performing sector in ’22, it demonstrated that being in the right sectors at the right time adds to outperformance.
The name of the game now is “adjust, adjust, adjust”. That has been THE focus since mid ’22. I felt that was the first step in dealing with the new Bear market and preparing for what could come next. I’ve now moved into phase two of my Bear market strategy. All of the details of my positioning today are found in my Marketplace Service updates.
While I find it amusing, it is only now that analysts/economists are talking about recession. The “cheerleaders” are running out of “rah rahs” and soon will have to deal with reality and offer a mea culpa for their complete denial of the facts. That has me wondering if the stock market hasn’t priced in a recession, or at least a very mild one. If that is truly the case, that adds more risk to this unsettling market scene.
I haven’t minced words on how I’ve felt about the economic backdrop that was littered with failed policies that spawned, then fed the inflation backdrop. An investment landscape that brought on this Bear market and the continued market turmoil. Those that failed to acknowledge the poor investment scene that was developing around them for well over a year now have paid the price.
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Best of Luck to Everyone!