The US Dollar index has risen for 9 weeks in a row. That’s only happened two other times: 2014 and 1997. Crude oil, meanwhile, has risen 10 of the last 12 weeks, and so has the price of 10-Year Treasury futures. Equity indexes were mostly unchanged for the week, and gold and bitcoin both rose modestly.
Nobody said getting inflation under control would be easy. After more than a year of decelerating price increases from last summer’s peak inflation rate, prices are heading the wrong way once again. Last week’s data release showed the Consumer Price Index jumped to 3.7% in August, up from June’s 3% annual rate, and still well above the Federal Reserve’s 2% annual target. A rebound in energy prices (thanks in part to the aforementioned rally in crude oil) is largely to blame for the disappointing inflation report, while the contribution from food and services continues to decline.
At this week’s FOMC meeting, Fed officials will have to contend with the troubling reversal in CPI while balancing the risks to economic growth.
Earnings Expectations and Valuation
The stock market selloff in 2022 was not driven by a deterioration in corporate earnings. Though stock prices dropped well over 20% from their peak to trough, expected future earnings remained stubbornly high. That divergence pushed the S&P 500 forward price-to-earnings ratio from more than 20x (a level previously seen only during the late-1990s) to 15x (a level in-line with historical averages).
The first half of 2023 was the opposite experience: stock prices rose, but earnings did not. Profits have now declined for three consecutive quarters. The ongoing correction in stock prices this August has served to dampen valuations a bit, but at nearly 19x next year’s earnings, equities are still far from cheap when compared to historical norms. Next year’s earnings are expected to rebound 11%.
Stock market returns were mixed last week. The NASDAQ Composite, which has been the leader all year, was the only major index to finish in the green. The S&P 500 index declined 0.8%, and the value-tilted Dow Jones Industrial Average erased half of its year-to-date gains when it dropped 1.2%. Crude oil cratered as much as 17% during the week, before rallying in the final two days to close only 7% lower. Gold, meanwhile, briefly touched an all-time high and had its best weekly close in nearly 3 years.
One Thing to Consider
The Federal Reserve raised rates for a tenth consecutive meeting yesterday. That wasn’t a surprise. Neither was it surprising when Chair Jerome Powell laid the groundwork for a pause in hikes, removing language from the prior meeting’s press release that indicated additional policy firming would be necessary, and replacing it with more flexible language that highlights the Fed’s data dependence going forward. After raising rates by 5% in just over a year, Powell believes policy is near a sufficiently restrictive level. Ever the pragmatic pivoter, he now wants to assess the extent to which their cumulative tightening actions, ongoing QT, and recent bank failures will affect credit creation and stymie demand. Friday’s jobs report, which exceeded expectations for the thirteenth consecutive month, showed how resilient this economy continues to be in spite of policy pressures.
Monitoring Macroeconomics
GDP continued to grow in the first quarter of 2023, though it was less than consensus expectations thanks to a large drawdown in inventories. Economists still widely believe that a recession will hit the United States sometime in the latter half of this year. The odds of a ‘soft landing’ – a scenario where the Fed successfully contains prices without creating widespread economic hardship – has declined, given price pressure that remain stubbornly elevated and the banking stresses that have emerged since March.
Measures of inflation remain well above the Federal Reserve’s 2% target, but CPI has decelerated for 9 straight months and measures of core price changes have dropped below 5%. Unemployment, meanwhile, is near 70-year lows, and job creation to start 2023 has been well above the level needed to keep pace with population growth.
What’s Ahead
Here are the key data releases to keep on eye on in the coming days.
Stocks moved higher last week, led by the NASDAQ Composite, which had its highest weekly close since last August. The NASDAQ is now up 16.8% for the year, nearly doubling the benchmark S&P 500 year-to-date performance. The US Dollar index fell slightly, but that wasn’t much of a tailwind for commodities. Crude oil dropped 1.4%, gold was mostly unchanged, and Bitcoin declined 1.4%. Long-term US Treasury bonds rallied 0.6%.
One Thing to Consider
Last week’s upside surprises for the Employment Cost Index and the PCE deflator all but ensured another interest rate hike at Wednesday’s FOMC meeting. The odds of a 0.25% move by the Fed are roughly 90%. While inflation data remains stubbornly high, GDP in the first quarter missed expectations. The 1.1% growth in the first quarter was the weakest since last spring, thanks to a sharp decline in inventories. Personal consumption, however, remained healthy during the period, and the drag from residential investment moderated. At his post-meeting press conference, Fed Chair Jerome Powell will be forced once again to explain how he views the risk of economic recession, and how that alters his approach in the battle against inflation.
Earnings Expectations and Valuation
The stock market selloff in 2022 was not driven by a deterioration in corporate earnings. Though stock prices dropped well over 20% from their peak to trough, expected future earnings remained stubbornly high. That divergence pushed the S&P 500 forward price-to-earnings ratio from more than 20x (a level previously seen only during the late-1990s) to 15x (a level in-line with historical averages).
So far, 2023 has been the opposite experience: stock prices are rising, but earnings are not. Profits are set to contract for a second consecutive quarter – an event commonly referred to as an earnings recession. The result is that valuations are elevated once again. The S&P 500 currently trades at a forward multiple of more than 18x.
What’s Ahead
Here’s the economic calendar for the week ahead. It’s jobs week, but that will be overshadowed by Wednesday’s FOMC decision.
Nearly half of S&P 500 constituents will report first quarter earnings over the next two weeks. If consensus expectations are correct, they’ll show that company profits are declining for a second straight quarter. Back-to-back EPS declines would signal the first ‘earnings recession’ since 2020, when COVID lockdowns brought the global economy to a grinding halt.
Since that time, corporate profits have risen at a pace that far exceeds the average annual EPS growth rate of 7%. Estimates for 12-month forward earnings are more than 60% higher than their 2020 lows.
Poised for an Earnings Recession?
Nearly half of S&P 500 constituents will report first quarter earnings over the next two weeks. If consensus expectations are correct, they’ll show that company profits are declining for a second straight quarter. Back-to-back EPS declines would signal the first ‘earnings recession’ since 2020, when COVID lockdowns brought the global economy to a grinding halt.
Since that time, corporate profits have risen at a pace that far exceeds the average annual EPS growth rate of 7%. Estimates for 12-month forward earnings are more than 60% higher than their 2020 lows.
Stimulus-fueled demand and record profit margins were largely to thank for that rise – but now those tailwinds have faded.
Revenues in the first quarter are expected to rise only 2% according to FactSet, substantially less than the annual rate of inflation. Profit margins are contracting, too, from last year’s elevated rate of 12.2%, to more modest 11.2%. Taken together, that points to an EPS decline of 6.5%. You rarely see that kind of drop outside of economic recessions.
Fortunately, actual earnings usually exceed expectations. In most years, consensus estimates trough in the weeks ahead of the reporting season, then hook higher as companies beat lowered expectations.
The average beat rate over the past 5 years? Over 8%. In other words, if corporate earnings exceed expectations at an average rate in Q1, we just might avoid that earnings recession. That’ll require the reversal of a 2 year trend, though.
Ever since earnings results outpaced expectations by 22% in Q1 2021, the beat rate has declined each quarter, reaching a low of 1.3% in the final quarter of 2022.
Early in the Q1 reporting season, profits are off to a strong start. We’ll see whether they can maintain the pace over the next two weeks, as more than 240 of the largest stocks announce operating results.
Focusing on the Fed
Since embarking on its latest monetary policy tightening cycle last March, the Federal Reserve has raised short-term interest rates by 4.75%. That’s pushed their target Federal Funds rate to its highest level since the onset of the Financial Crisis 15 years ago. More than that, the pace of hikes is faster than anything we’ve seen since the 1980s, when Paul Volcker pushed rates as high as 20% in his efforts to break the back of inflation.
Current chair Jerome Powell has channeled his inner Volcker during this era’s battle with inflation. He’s repeatedly warned against the risks of prematurely declaring victory, pointing at the Fed’s failures during the 1970s to restore price stability. Back then, policy was loosened each time the economy softened. That allowed smoldering price pressures to reignite, argues Powell. He’s reluctant to make the same mistakes.
That hasn’t kept market participants from pricing in rate cuts later this year, though, thanks to expectations of a looming economic downturn. Recession risks were already elevated as we entered 2022, and the failures of Silicon Valley Bank, Credit Suisse, and Signature Bank of New York served only to raise them further. If turmoil in the banking sector causes banks to reign in lending and credit creation, recession could come sooner and hit harder.
That’s the belief of the Fed’s staff economists, too. According to minutes from the March FOMC meeting, the staff projects a mild recession in the second half of this year. Previously, they’d anticipated low but continued growth.
Despite Powell’s protestations, the market believes he’ll cave to pressure and loosen policy if an economic downturn does arrive. Two year Treasury yields tend to reflect investors’ expectations of future interest rate policy. After SVB’s failure in mid-March, 2-year yields dropped more than 1%, and they remain more than three-quarters of a point below last month’s peak.
Fortunately for Powell, price pressures are receding, which could make it easier to support economic growth. In the month of March, growth in the Consumer Price Index dropped to a 5% annual rate, the lowest level since spring 2021. Goods inflation – primarily thanks to a drop in energy prices – has all but disappeared. Measures of housing costs could soon be headed lower, too. BLS estimates of shelter inflation notoriously lag real-world economic data, and those data imply housing inflation will taper off in early summer.
Still, inflation remains well above the Fed’s target, and the Fed’s own projection materials show they don’t expect to reach that target until 2025. A lot could happen before then.
For one, OPEC’s surprise decision to cut production a few weeks ago has oil prices back on the rise. That may be enough to keep Powell & Co. from lowering rates any time soon – even if a recession unfolds.
Inflation showed further signs of slowing last week, as the year-over-year change in CPI decelerated to 5%, the lowest level since May 2021. Falling energy prices contributed to the decline, with prices for energy commodities dropping 17%. Core inflation – which excludes volatile food and energy components of the index – was less compelling. It accelerated to 5.6% year-over-year, still well above the Federal Reserve’s 2% target.
Week in Review
Stocks added to year-to-date gains last week, led by a 1.2% rise in the Dow Jones Industrial Average. The NASDAQ lagged, rising 0.3%, and the S&P 500 climbed 0.8%. Interest rates rose and the Dollar fell, while gold prices ended the week unchanged after a Friday selloff. Bitcoin jumped 8.5%, ending the week above 30,000 for the second straight week. Crude oil had its best finish of the year closed at levels not seen since last November.
Inflation showed further signs of slowing last week, as the year-over-year change in CPI decelerated to 5%, the lowest level since May 2021. Falling energy prices contributed to the decline, with prices for energy commodities dropping 17%. Core inflation – which excludes volatile food and energy components of the index – was less compelling. It accelerated to 5.6% year-over-year, still well above the Federal Reserve’s 2% target. Nearly a third of that number is comprised of housing costs, which most economists believe will begin to show meaningful disinflation this summer.
Relatively Speaking
Gains in stock prices were broad over the last month, as only the Real Estate sector failed to finish in the green. Communication Services was far and away the best sector, as the group jumped 12% – more than double the 5.5% rally for stocks overall. Energy, Information Technology, and Health Care all outperformed as well.
For the year, growth-oriented sectors are comfortably in a leadership position. Communication Services is again the best performer, with prices 24% higher since December. Information Technology and Consumer Discretionary are both up double-digits. Five sectors, meanwhile, are in negative territory for the year. Risk-off sectors like Health Care, Real Estate, and Utilities have fallen out of favor after being leaders in 2022. Financials, thanks in part to weakness in the banking industry, are lagging the S&P 500 by 11%.
What’s Ahead
Updates on the housing market dominate this week’s busy economic calendar.
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