Pro Perspectives 1/31/23

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January 31, 2023
 
The Fed will decide on rates tomorrow.  The Bank of England and the European Central Bank will follow with rate decisions on Thursday morning. 
 
By Thursday afternoon, U.S. benchmark rates will be 4.75%, the UK will be at 4% and the euro zone will be at 3%.
 
Now, as we discussed last Thursday, this level of interest rates in the U.S. has already resulted in more than a quarter of a trillion dollars in additional interest payments on U.S. sovereign debt.  
 
This will be funded by more deficit spending, which compounds an already massive, and unsustainable, government debt-load.
 
What does unsustainable look like?  See the UK and Europe.  They've already had a run on their vulnerable sovereign debt markets, in the second half of last year.  And both respective central banks were forced to (once again) become the buyer of last resort, to prop up their government bond markets, to avert a spiral toward default.
 
As we discussed last week, this unsustainable debt problem is precisely why the world needs inflation.  Governments need to inflate away the value of debt.  But it only works if, simultaneously, we have hot growth.  And it only works if wages reset/adjust to maintain the standard of living.
 
The good news:  Though with a healthy mix of government intervention along the way, the major central banks of the world (excluding Japan) have somewhat normalized interest rates, without killing the job market and the consumer.
 
With the fundamentals in place for continued solid consumption, and with China re-opening and the Western world rate cycle coming to an end, we are positioned to see some hot economic growth.   That would align with a persistently higher inflation environment, but one that can inflate away debt problems.  To regain, and maintain, standard of living, wages need to reset higher. 

Pro Perspectives 1/30/23

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January 30, 2023
 
It's Fed week.  The Fed is expected to raise another quarter point on Wednesday.  That will take the Fed Funds rate to the range of 4.5%-4.75%.
 
And as we discussed on Friday, that would take short term rates ABOVE the rate of inflation, which is historically the formula for beating inflation. 
 
In this case, instead of chasing inflation, the Fed used a new mix of tools (which included help from the White House on gas prices) to manufacture a (somewhat) meeting in the middle of inflation and interest rates.  
 
Here's another look at the chart, as it will stand on Thursday…
If we step back and take an objective look at the "point-in-time" data, we have an economy that grew at a near 3% pace in Q4.  Inflation expectations remain tame.  The job market is tight.  Household net worth has dipped, but from record levels.  It's still 23% higher than it was pre-pandemic. 
 
Consumers are taking on more credit, but doing so with record high credit scores and historically strong balance sheets.  With that, as you can see in the chart below, household debt service has returned to pre-pandemic levels (which were record lows at the time). 
Bottom line:  The fundamentals for consumption remain very solid, even with the introduction of an historically normal/average interest rate (for the first time in 15-years). 

Pro Perspectives 1/27/23

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January 27, 2023
 
The Fed’s favored gauge of inflation is core PCE (personal consumption expenditures).  It measures the change in prices of goods and services that people have actually paid — not just a selling price. “Core,” means excluding food and energy prices. 
 
The December report on core PCE came in this morning. 
 
With the Fed meeting next Wednesday, how might this most important data point guide them on next moves? 
 
The answer:  It should give them justification to pause on the tightening cycle.  
 
Why? 
 
As we’ve discussed often here in my daily notes, the inflation storms of the past have only been quelled when interest rates are taken ABOVE the rate of inflation.
 
In this case, the Fed has used a combination of tools to manufacture the desired outcome.  They’ve used a combination of rates, quantitative tightening AND a copious amount of talking (talking markets down, talking demand down).
 
With that mix, the Fed managed to stop the rise in core PCE early last year, and reverse it, without having to take rates to the double-digit levels of the early 80s. 
 
So, we now have the latest year-over-year change in core PCE at just 4.4%!  
 
As you can see in the chart below,  assuming the Fed goes through with another quarter point hike next Wednesday, we will have interest rates (the effective Fed funds rate) ABOVE the rate of inflation (core PCE).
 
This should give the Fed plenty of justification to hit the pause button, as the Bank of Canada has just done.    

Pro Perspectives 1/26/23

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January 26, 2023
 
As I said in my Tuesday note, we are in a hot economy, where demand is being throttled by the Fed. 
 
This was intended to be a reminder, with all of the recession talk, that this is not the economy of the post-financial crisis decade.  It's a not a sputtering economy with a demand problem.
 
The Fed is holding the beach ball under water.
 
With that, I posed the question, "what happens when the Fed backs off (let's go)?"
 
Some say that's precisely why they won't.
 
That makes sense, assuming they had a choice.  They don't.
 
They have this thing called debt service to think about it.
 
Let's take a look at what the Congressional Budget Office (CBO) has said about the sensitivity of debt service to the Fed's tightening campaign. 
 
If rates rose faster than their projections, they estimated that each 100 basis points higher would equate to $187 billion in additional annual interest costs.
 
Indeed, they have undershot a Fed that moved 425 basis points in nine months. 
 
The result:  About a quarter of a trillion dollars in additional interest payments for 2022.  And this year, if the Fed does what it projected in December (5.1% on the Fed Funds rate), and if the 10-year yield reverts to its historical average spread of 90 basis points (above the Fed Funds rate), the  Fed will have inflicted another $600 billion of interest payments on the U.S. government. 
 
That will be funded by larger and larger deficits.  And that compounds an already massive, and unsustainable, government debt-load.  
 
Ironically, this unsustainable debt problem is precisely why we need inflation.  We need to inflate away the value of the debt.  But it only works if, simultaneously, we have hot growth.  And it only works if wages reset/adjust to maintain the standard of living.
 
So, if we're lucky, we've just seen phase one of this inflationary environment, where the Fed normalizes interest rates.  Now, phase two should be a Fed that sits tight, let's growth bounce back (driven by the mountain of new money created over the past three years), inflation will bounce back with it, and, as they are doing in Japan, policymakers should encourage employers to raise wages.   

Pro Perspectives 1/25/23

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January 25, 2023
 
The price action in stocks should have the bears very worried. 
 
Regardless of where the futures markets have traded overnight,  for the past four sessions, when the cash market opens, stocks have gone straight up (chart below).  
What does it mean?

 
The speculator types can dominate futures trading overnight, and at times can set the tone for the way the cash market trades on the day.  In this case, when the "real money" comes into the market (i.e. large institutional money managers), there is clearly appetite to put cash to work.
 
This comes as the world's stock market proxy (S&P 500) has technically broken out (a bullish breakout).  And it comes as we head into next weekend's Fed meeting. 
 
Of course, Fed policy has been the primary burden on the stock market for the past year.  And that burden might be lifted as soon as next Wednesday, with any indication that they are ready to pause the rate cycle.
 
On the latter, the Bank of Canada may have kicked off this new "pause" phase on global monetary policy this morning.
 
Here's what they said:  "If economic developments evolve broadly in line with the forecast we published today, we expect to hold the policy rate at its current level while we assess the impact of the cumulative 425 basis point increase in our policy rate.  We have raised rates rapidly, and now it's time to pause and assess whether monetary policy is sufficiently restrictive to bring inflation back to the 2% target." 

Pro Perspectives 1/24/23

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January 24, 2023
 
Coming into the year, the consensus view for Q4 earnings season was for a 3.2% decline in S&P 500 earnings.
 
The noise in the media was for something much worse (an "earnings bust").  
 
So far, it isn't the blood bath some were expecting.
 
Keep in mind, this comes in a quarter where the economy was likely growing at a better than 3% annual clip.   
 
Also keep in mind, when given the opportunity (with low expectations already built in), corporate America will put all the bad news they can muster on the table, lowering the expectations bar, so that they can set up for positive surprises in future quarters.   

 
That said, we kicked off earnings with the big four banks.  They all set aside capital, adding to what is already a war chest of reserves from the quarters that followed the pandemic lockdowns.   If we add these new Q4 allowances for potential loan losses back, all four of the biggest four banks in the country would have beat earnings estimates, AND improved on the earnings from the same period a year ago.  
 
Bottom line:  It's not a sputtering economy with a demand problem. It's a hot economy, thanks to the deluge of money still floating around, where demand is being throttled by the Fed.  What happens when the Fed backs off? 
 
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Pro Perspectives 1/2323

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January 23, 2023
 
We ended last week looking at this chart …
As you can see, this big trendline in the S&P broke today.
 
A similar trendline in the Nasdaq also broke today.
 
The Dow is above the 200-day moving average, and has been for two months.
 
German stocks broke out of the downtrend a little more than two months ago, and now trade 27% higher (from the lows).
 
British stocks are just a little more than 1% off all-time highs.
 
And as we discussed Friday, Chinese stocks are on the move.  Several catalysts have lined up to drive both domestic and global growth, not the least of which is the end of zero covid policy. 
 
So, all of this, and we are a little more than a week away from an event that has been the sentiment spoiler for much of the past year:  another Fed meeting.
 
Since August, the Fed has made a clear effort, through rate hikes, guidance and threats, to tighten financial conditions.  And yet, the Chicago Fed's National Financial Conditions Index (which measures credit, risk and leverage) is just about where it was when the Fed started raising interest rates.  
 
And if you look at a chart of that index (below), you can see what today's level looks like (far right on the chart), relative to the levels in each of the past seven recessions (indicated by the shaded gray areas).  It's not close to looking like recession. 
Now, despite this setup above, the Fed has worked hard to quash any bubbling up of optimism along the path of the past year.
 
They’ve left nothing on the table.   
 
With all of the bullets they’ve fired, it’s hard to imagine how, at this stage, they could negatively surprise markets next week. 
 
They’ve already told us they want to take the Fed Funds rate another 75-100 basis points higher.  They’ve already dialed down their forecast on economic growth to almost nothing (just 0.5% for 2023).   And they’ve told us they think unemployment is going a percentage point higher.  
 
This, as the very inflation they profess to still be fighting most recently printed in negative territory (i.e. deflation from November to December).  The monthly change in prices over the past seven months averages to just 0.12%.  Annualize that, and inflation has been running below the Fed’s 2% inflation target, for many months now.
 
And we’ll head into next week’s meeting with a GDP report, due this Thursday, that will show an economy that grew at a better than 3% annual rate last quarter. 
 
Bottom line:  The Fed will have a very difficult time coming up with something to damage the momentum in markets.  
 
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Pro Perspectives 1/20/23

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January 20, 2023
 
As we end the week, let's take a look at a few charts.
 
First, here's a look at U.S. stocks …
As you can see this big technical trendline we've been watching, still holds.  This is the trend that defines the bear market of last year.  Interestingly, the last two tests of this line coincided with two very important inflation reports.
 
Stocks failed into this line both times, despite the improving inflation picture from both reports.  Why?  It was largely because the Fed went on the offensive immediately (against potentially easing financial conditions).  They were  quick to combat improving sentiment in markets with more threats of higher interest rates.
 
That said, it looks like we will get another test of the trendline in stocks next week. 
 
Meanwhile, if we look at the bond market, the big trendline here has broken (in yields) …
For the better part of the past thirteen years, we've been used to seeing yields plunge/bonds soar on the view of (more) emergency monetary policy coming and/or heightened fear (i.e. safe haven flows into bonds).
 
In the current case, after the 60/40 bond portfolio had the worst year on record, the world is pouring money into bonds to start the year, both to capture the best yield in a long time, and also seeking bond price appreciation.  Bond returns and bond sales are off to the best start to a year ever. 
 
Finally, let's take a look at Chinese stocks …
It was in June of last year that things appeared to be opening up in China, and the economy was in an upswing,  and then by July another wave of infections hit, and the government went back to lockdowns.  You can see in the chart above, the ETF that tracks large cap Chinese stocks (symbol FXI) broke to new lows.  
 
Now we have a number of catalysts working in favor of Chinese stocks, including a number of monetary and fiscal stimulus measures over the past several months.  Then the government scrapped its zero covid policy.  And now it appears they are relaxing restrictions on their real estate market.  Stocks are moving. 
 
On China, as we discussed in my Jan 5 note, "a faster rate of change in foreign interest rates, relative to the U.S., means money will move out of the dollar (weaker dollar).
 
For those searching the world for value, with a catalyst, it can be found in emerging market Asia.  If history is our guide, this is likely where we will see the best stock market performance in the world over the next few years." 
 
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Pro Perspectives 1/19/23

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January 19, 2023
 
If we look back over the past 13 years, investors have had plenty to worry about.  
 
Let's step through the post-Great Financial Crisis period. 
 
Following the global government and central bank rescue efforts and stimulus of 2009, Wall Street told us the era of developed world dominance had come to an end, and that the future of investing was in China.  By 2010, it was obvious that China couldn't thrive while the Western world economies were suffering.  The slowdown in China became the worry for markets.
 
In 2011, during a debt ceiling fight on Capitol Hill, Standard and Poor downgraded the U.S. credit rating, cutting it from AAA.
 
Next up, Europe: Europe was on the brink of a sovereign debt default and collapse of the euro, over the course of a few years.  
 
Then we had Ukraine/Russia 1.0.  Then the Chinese stock market crashed, and China shocked global markets with a surprise currency devaluation.  
 
Then oil prices crashed.  
 
Then Trump entered, and was immediately impeached.  
 
Then the world was shaken by the U.S./China trade war.  Then we had a global pandemic.  Then we had rampant, 40-year high inflation.  And then we had Ukraine/Russia 2.0.  
 
Along the way, stocks climbed the wall of worry.  Including dividends, the S&P 500 delivered eleven wining years, averaging 17.6% — and two losing years, averaging down 11.3%.  Fourteen years later, and throughout all of the chaos listed above, every dollar in the stock market is worth $3.48. 
 
Here we are in 2023, and again, there is plenty to worry about, including another debt ceiling saga.  Why does a "wall of worry" tend to be constructive for bull markets?  Because it breeds positive surprise. 
 
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Pro Perspectives 1/18/23

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January 18, 2023
 
The Bank of Japan held its ground overnight.  They kept key short term rates negative.  And they maintained the cap on their 10-year government bond yield at half a percent.
 
So, Japan continues with pedal-to-the-metal stimulative policy, even as inflation is running at four decade highs.  And even as the rest of the world is well into tightening campaigns. 
 
What did the the BOJ governor have to say?  
 
He said he wouldn't hesitate to ease further if necessary.
 
He said it's important to support the economy.
 
And he said it's important to encourage companies to raise wages.
 
These are three diametrically opposite initiatives of that of the rest of the Western world. 
 
The Fed has threatened to tighten more (err on the side of too tight), has explicitly worked against the economy, and has outright wanted to suppress wage gains.  
 
For context, it's important to remember that Japan has been attempting to reverse nearly three decades of deflation.  Former Prime Minister Abe was elected 11 years ago on the promise of ending the economic malaise and deflationary vortex that had troubled Japan for more than two decades. And he hand-selected a governor of the Bank of Japan (Haruhiko Kuroda) to execute an all out war on deflation.
 
So Kuroda is not going to let up (not on his watch).  After dealing with three decades of deflation, he's going to let the economy run hot.  And he's focused on preserving standard of living (against inflation) by encouraging wage growth.  Meanwhile, hot nominal growth solves a lot of problems.  It's a recipe for inflating away the government debt burden (Debt/GDP goes down).
 
It's a logical game plan.  And it's a game plan the Fed and Treasury appeared to be executing in the early response to the pandemic shut-down.  They erred on the side of being over-aggressive.  They printed and they spent, and they restored economic output inside of a year.  They stoked hot nominal growth, which inflates away the debt burden. 
 
But then the political pendulum shifted, and restoring economic prosperity was abandoned for the global climate agenda.
 
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