In 2022, when the Fed was battling inflation, bad economic news was “good” and vice versa. Every data point that showed slowing jobs, lower earnings and a decline in spending put investors at ease in hopes that the Fed would win the battle over rising global inflation and not raise rates too far. “Don’t fight the Fed” is a very reliable market truism. The quicker they stop tightening, the quicker we can get back to normal. Now that Fed Funds are nearing 5%, the concern becomes whether they did too much and how bad of a recession is coming down the road. Inflation is clearly declining, so 2023 is turning into a recession watch. Bad news is bad, as seen this week.
A rough retail sales report on Wednesday led to a quick 3% drop in the S&P on fears that the consumer is in full retrenchment mode. December showed a 1.1% decline in overall sales, the largest of the year, and an unexpected soft ending to the critical holiday season. Even worse, sales have now fallen in three of the past four months. In other ominous economic news, auto loan delinquencies over 60 days due are up 27% from last year. Homebuyer cancellation rates are spiking, as affordability, interest rates and lending tightness wreaks havoc on sellers. Looking ahead, the student loan payment pause is expected to finally come to an end this summer. That means that over $1 trillion in student debt forbearance begins to get paid back, taking another chunk out of discretionary spending.
Consumers are rapidly depleting those Covid savings as well, with under $1T left in accounts, relative to the ~$2.5T in 2020. Inflation rates are still higher than wage gains, meaning purchasing power has been declining. Those handouts and excess savings are helping the economy to grow, but eventually will come to an end. A strong consumer is turning into a more frugal one, which precedes a full-on recessionary retrenchment in spending. Stocks took it on the chin following a realization that soft landings are rare.
One of the bullish themes for months now has been the hope that the Fed will pivot and stop raising rates, or even start cutting. Fed Funds futures are predicting an easing cycle to start later this year. Fed officials continue to preach higher for longer, getting above 5% on Fed Funds (4.25% – 4.50% today), and not cutting until 2024. Quite the difference.
Here is where even more confusion lies. Those buying stocks today, in hopes of a change in policy, are not studying their history. Looking back over the past 13 rate hiking cycles where the Fed changed course, pointed to a median loss of 28% for stocks relative to bonds. The reasons for a Fed pivot are BAD for risk assets, not good. The Fed’s track record of overdoing it before turning back to easing is not great to say the least. This period could be even more critical as every Fed official is preaching the mistake which occurred during the 70’s where every minor economic slowdown was quickly met with money printing and Fed easing. Inflation kept coming back and lasted over a decade. Our Fed officials today are clearly trying to avoid that. In effect, the only thing that will make them pivot is a horrible jobs market, a deeper than expected recession and deflationary conditions. None of this is good for stocks!
Here are the last 13 periods that saw a change in Fed policy with the performance of the S&P vs. 10-Year Bonds. Feel free to email me for a clean version: (email@example.com)
Bond Versus Stock Investors:
To say that these markets have different outlooks would be an understatement. Last year, both suffered as inflation and Fed rate hikes helped collapse stock and bond prices. Since then, longer-term interest rates have reversed gears and dropped substantially. The 10-year Treasury peaked in October with a 4.33% yield. Today, it is down almost 100bps to 3.39%. Bond investors are not worried about inflation anymore and have seen an influx of cash leaving stocks to find a safer, more reliable home. Concerns about growth and the Fed going too far have been the story for months now.
Further, the end of every Fed Rate hiking cycle since 1974 has heralded a period of lower interest rates and a recession. The average yield change AFTER the last Fed rate hike for 10-year Treasuries was nearly 100bps lower. Considering the Fed is not even not raising rates yet, history would say the 10-year yield could be ~2.5% next year.
Stocks on the other hand are not looking at a similar outcome. Dating back to 1950, the stock market has NEVER bottomed before the recession started. Most estimates show that Q422 was another positive GDP quarter, so it is unlikely that the market bottom in October was during a recession. While the bond market is pricing in a massive slowdown for economic activity, stocks are still hopeful for that soft landing and minimal damage to corporate profits.
Again, it is highly unlikely that the Fed will change course on inflation unless something breaks. If something breaks, stocks are certain to suffer. The last four bear markets ended with P/E ratios of 13x, 10x, 14x and 16x. Currently, estimates project a P/E of 17x today. This also assumes that margins stay elevated and analysts are correct on the “E” in P/E, which would also be a rare occurrence.
At the end of the day, bond and stock investors both make mistakes. Something in the middle of these 2 markets is quite possible, if not probable. A decline in rates is very bullish for early cycle markets such as autos and housing. Consumers are still in decent shape, a rare occurrence this deep into a bear market. They do not have to fully retrench if inflation collapses. Supply chains are rebalancing, numerous commodities are rolling over, oil is dropping, all of which will help spending power later in 2023. Corporations are getting religion on overhead costs as layoffs pile up in the technology sector (look at massive layoffs at Microsoft# and Google# this week), which should help contain wage gains. China is reopening and pumping money into their system. Many other central banks are either done raising rates or hinting at easing over the coming year. History also says that once inflation is beaten, stocks roar. That is a plausible scenario here too, albeit lower probability due to valuations.
While bond and stock investors are pricing wildly different outcomes, they will converge at some point. This continues to be a stock pickers market, and quick gains like what we saw in a lot of heavily shorted names or little to no earnings companies, are gifts to be taken. Every bear market has an end, which leads to a new, stronger bull market. Investing under these conditions requires patience and an investment strategy that relies on earnings, cash flows, low debt levels and leadership products for a new era.
Roblox (ask your kids or grandkids) creator David Baszucki turns 60 today. Rainn Wilson is 57 and Buzz Aldrin turns 93. Lastly, our Super Bowl Hero, Nick Foles, celebrates 34 today. Go Birds!!!
James Vogt, 610-260-2214