Scott Martindale  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Investors found optimism and “green shoots” in the latest CPI and PPI prints. As a result, both stocks and bonds have rallied hard and interest rates have fallen on the hope that inflation will continue to subside and the Fed will soon ease up on its monetary tightening. Still, there is a lot of cash on the sidelines, many investors have given up on stocks (and the longstanding 60/40 stock/bond allocation model), and many of those who are the buying the rally fear that they might be getting sucked into another deceptive bear market rally. I discuss in today’s post my view that inflation will continue to recede, stocks and bonds both will gain traction, and what might be causing the breakdown of the classic 60/40 allocation model—and whether stocks and bonds might revert back to more “normal” relative behavior.

Like me, you might be hearing highly compelling and reasoned arguments from both bulls and bears about why stocks are destined to either: 1) surge into a new bull market as inflation falls and the Fed pivots to neutral or dovish…or 2) resume the bearish downtrend as a deep recession sets in and corporate margins and earnings fall. Ultimately, whether this rally is short-lived or the start of a new bull market will depend upon the direction of inflation, interest rates, and corporate earnings growth.

The biggest driver of financial market volatility has been uncertainty about the terminal fed funds rate. DataTrek observed that the latest rally off the October lows closely matches the rally off the 12/24/2018 bottom, which was turbocharged when Fed Chair Jerome Powell backed down from his hawkish stance, which of course has not yet happened this time around. Instead, Powell continues to actively talk up interest rates (until they are “sufficiently restrictive”) while trying to scare businesses, consumers, and investors away from spending, with the goals of: 1) demand destruction to push the economy near or into recession and raise unemployment, and 2) perpetuate the bear market in risk assets (to diminish the “wealth effect” on our collective psyche and spending habits). Powell said following the November FOMC meeting that it is “very premature” to talk about a pause in rate hikes.

Indeed, the Fed has been more aggressive in raising interest rates than I anticipated. And although some FOMC members, like Lael Brainard, have started opining that the pace of rate hikes might need to slow, others—most notably Chair Powell—have stuck unflinchingly with the hawkish inflation-fighting jawboning. However, I think it is possible that Powell has tried to maintain consistency in his narrative for two reasons: 1) to reduce the terminal fed funds rate (so he won’t have to cut as much when the time comes for a pivot), and 2) to not unduly impact the midterm election with a policy change. But now that the election has passed and momentum is growing to slow the pace given the lag effect of monetary policy, his tune might start to change.

As the Fed induces demand destruction and a likely recession, earnings will be challenged. I believe interest rates will continue to pull back but will likely remain elevated (even if hikes are paused or ended) unless we enter a deep recession and/or inflation falls off a cliff. Although the money supply growth will remain low, shrinking the Fed balance sheet may prove challenging due to our massive federal budget deficit and a global economy that is dependent upon the liquidity and availability of US dollars (for forex transactions, reserves, and cross-border loans)—not to mention the reality that a rising dollar exacerbates inflationary pressures for our trading partners and anyone with dollar-denominated debt.

Thus, the most important catalyst for achieving both falling inflation and global economic growth is improving supply chains—which include manufacturing, transportation, logistics, energy, and labor. Indeed, compared to prior inflationary periods in history, it seems to me that there is a lot more potential on the supply side of the equation to bring supply and demand into better balance and alleviate inflation, rather than relying primarily on Fed policy to depress the demand side (and perhaps induce a recession). The good news is that disrupted supply chains are rapidly mending, and China has announced plans to relax its zero-tolerance COVID restrictions, which will be helpful. Even better news would be an end to Russia’s war on Ukraine, which would have a significant impact on supply chains.

In any case, it appears likely that better opportunities can be found outside of the passive, cap-weighted market indexes like the S&P 500 and Nasdaq 100, and the time may be ripe for active strategies that can exploit the performance dispersion among individual stocks. Quality and value are back in vogue (and the value factor has greatly outperformed the growth factor this year), which means active selection is poised to beat passive indexing—a climate in which Sabrient's GARP (growth at a reasonable price) approach tends to thrive. Our latest portfolios—including Q4 2022 Baker’s Dozen, Forward Looking Value 10, Small Cap Growth 36, and Dividend 41 (which sports a 4.8% current yield as of 11/15)—leverages our enhanced model-driven selection approach (which combines Quality, Value, and Growth factors) to provide exposure to both: 1) the longer-term secular growth trends and 2) the shorter-term cyclical growth and value-based opportunities.

By the way, if you like to invest through a TAMP or ETF, you might be interested in learning about Sabrient’s new index strategies. I provide more detail below on some indexes that might be the timeliest for today’s market.

Here is a link to a printable version of this post. In this periodic update, I provide a comprehensive market commentary (including constraints on hawkish Fed actions and causes of—and prognosis for—the breakdown of the classic 60/40 portfolio), discuss the performance of Sabrient’s live portfolios, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a modestly bullish bias, the technical picture looks short-term overbought but mid-term bullish, and our sector rotation model has moved from a defensive to neutral posture. Read on...

Scott Martindale  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Federal Reserve chairman Jay Powell sounded quite hawkish at his brief Jackson Hole speech on Friday, and investors were spooked. But keep in mind, he will be reacting to the inflation data as it comes. And although the CPI hit 40-year high of 9.1% YoY in June, I see plenty of signs that inflation is in retreat. Many commentators have been attempting to predict the future of inflation and the economy by making comparisons with prior periods of high inflation. But what makes today’s situation unique is the impact of artificial supply chain disruption due to forced lockdowns rather than economic forces. Thus, I believe the Fed has been trying to “buy time” to allow supply chains to mend by using hawkish rhetoric and creating as much demand destruction as possible – without overtly crushing the economy into recession (a la Paul Volcker). Here are some of the signs that inflationary pressures are receding:

  1. CPI began to flatten out in July after 16 straight months of increases, coming in at 8.5% YoY (after topping out at 9.1% in June).
     
  2. Business inventories have risen sharply (according to the St. Louis Fed), which implies disinflationary pressure on finished goods, and the important inventory/sales ratio is making its way back to pre-pandemic levels. Wholesale prices and import prices both came in better than predicted, and commodity prices, shipping rates, and home prices are all either stabilizing or falling.
     
  3. The Fed’s preferred inflation gauge – Personal Consumption Expenditures (PCE) Index excluding food and energy – has slowed each month since its February peak, falling from 5.3% to 4.7%.
     
  4. July PPI data fell 0.5%, which was the first decline in producer prices since pre-pandemic. Historically, large moves to negative PPI readings like this have led to significantly lower inflation over subsequent months.
     
  5. The New York Fed’s Global Supply Chain Pressure Index (GSCPI) has been falling rapidly since the start of the year.
     
  6. The St. Louis Fed’s 5-year Breakeven Inflation Rate has fallen to 2.73%, and the 5-year/5-year Forward Inflation Expectation Rate is only 2.41%. Also, the University of Michigan Inflation Expectations survey of consumers, median expected price change, are at 4.8% for the next 1 year and 2.9% for the next 5 years.
     
  7. Gold prices continue to languish due to the ultra-strong dollar and expectations for rising real interest rates (nominal rate minus inflation). Historically, gold thrives when inflation rises and real interest rates fall, leading to a weaker dollar, which makes gold attractive as a store of value. But there has been no rush among investors to hold gold.

Of course, Fed monetary policy can only impact demand; it has no impact on disrupted global supply chains. The Fed can only withdraw stimulus by unwinding QE (i.e., letting bonds on its balance sheet mature and/or selling some into the market) and raising interest rates to the “neutral rate.” In fact, I believe we are close to that elusive neutral rate, given how sensitive the highly leveraged US and global economies (consumers, businesses, and governments) have become to debt financing costs. Moreover, the Fed must ensure sufficient global supply of dollars in a world hungry for them (85% of foreign exchange transactions, 60% of foreign exchange reserves, and 50% of cross-border loans and international debt are in US dollars.) All ears will be on the September FOMC meeting on 9/21, when the Fed may announce a final rate hike followed by language indicating that it will “wait & see” how conditions develop going forward (in spite of the tone of Powell's written speech on Friday). 

smartindale / Tag: inflation, federal reserve, CPI, PPI, GSCPI, FOMC, stocks, neutral rate, interest rates / 0 Comments