Pro Perspectives 11/3/22

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November 3, 2022
 
Following yesterday's Fed meeting, the 10-year yield is trading well above 4% again. 
 
Rising U.S. yields, on the expectations of higher Fed rates, strengthens the dollar, and drags global interest rates higher — both of which create strains in global sovereign debt markets. 
 
As you can see in the chart, this area for U.S. yields has, in recent history, resulted in damage, and (related) central bank intervention. 
Now, with this, and with a very high stakes election coming next week, let's talk about what has taken the world's most influential interest rate market to this damaging 4%+ level.
 
Remember, it was only three months ago that the Fed raised the short term rate to 2.5%, and in the post-meeting press conference, Jerome Powell called that level "neutral" (i.e. not accommodative nor restrictive of economic activity).  And he said they would no longer "guide" on policy, but take things meeting by meeting, dependent on the data.
 
That was the stopping point for rates. 
 
What happened?  Before the day ended, the Democrat-controlled government demonstrated that getting their agenda done was a higher priority than securing economic stability (much less prosperity). 
 
They countered the Fed's inflation fight, by pouring more fuel on the inflation fire.  They went on a $1.5+ trillion spending binge over the following month.  That forced the Fed back on the offensive.
 
Again, among many other reasons, the opportunity to de-seat Democrat power in Congress makes this election very high stakes.  With a flip in the House and the Senate (both of which are projected), the Republican-led Congress can go to work dismantling some of this spending.  That would cool the inflation outlook, and take pressure off of the Fed.  

Pro Perspectives 11/2/22

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November 2, 2022
 
In the September Fed meeting, the expectations were set for another 125-150 basis points of rate hikes by year end. 
 
The Fed followed that meeting with a very active media campaign, where they told us, on a daily basis, that they would do whatever it takes to slay inflation.
 
So, coming into today's Fed decision, the expectations were set for another 75 basis point hike.  The Fed delivered on that. 
 
And coming into today's Fed decision, the interest rate market was pricing in about a coin flip chance of another 75 basis point chance in December. 
 
By the end of today, markets are pricing in a better chance at 50 bps for December.  That's somewhat less severe.
 
If we were looking for positives from the Fed commentary today: 
 
1) The Fed statement acknowledged the, yet to be felt, cumulative effect of 375 basis points of tightening on economic activity and prices (i.e. the rate hikes have a lagging effect).
 
2) They acknowledged that financial conditions are tighter, due to their policy actions.
 
3) Powell acknowledged that inflation expectations are still well anchored.  Of course, this is what the Fed cares most about, as losing control of inflation expectations can quickly result in consumers pulling purchases forward, with the idea that prices will be higher tomorrow.  And thus, a price spiral. But inflation expectations have been tame, mostly attributed to the Fed's threats to economic activity and to financial market health.
 
So, these three points are all quite positive, especially given that the monthly inflation readings over the past three months have come in tame. 
 
There is a clear case for "mission accomplished."  Sit and watch.  
 
Still, the Fed continues to err on the side of overtightening, and they want us to know it.   
 
On the negative side for stocks and the economy today, Powell intentionally wanted to hammer home four points:
 
1) They have more "ground to cover" on rates. 
 
2) They think they will get to a higher level on the Fed Funds rate now, than they forecast just two months ago. 
 
3) Powell made an effort to include in his "off-script" Q&A session that he thinks "it's very premature to think about pausing (on rate hikes)."  Emphasis, very.
 
4) And, he says they are committed to bringing inflation down (erring on the side of overtightening).
 
Now, with all of the above in mind, remember the Fed, largely, set these expectations back in September.
 
And as we've discussed, more important, at this stage, is what happens next Tuesday. 
 
The betting markets continue to price in a better than 70% chance of a Republican sweep of Congress.
 
In that scenario, the spigot on any additional fiscal spending would be closed. Moreover, the inflationary policies that have already been approved (including Build Back Better/IRA) would be challenged. If that plays out, the Fed would find themselves in a position where they have overtightened, already.  

Pro Perspectives 11/1/22

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November 1, 2022
 
We the Fed decision tomorrow, let's take a look at the most recent inflation data, which they are supposed to be "dependent" upon for making policy decisions.
 
Here's a chart of the consumer price index.  This is the "headline" number, including food and energy.  And it's from this index that the big 8%+ number is calculated (current, compared to the same period a year ago).   
Notice the consumer price index has flattened since June (i.e. very little inflation). Also notice the levels from a year ago, which the current CPI reading is being measured against.
 
The takeaway: Even if inflation flat-lined from here, it would be many months before the year-over-year inflation number dropped materially. In fact, if CPI flat-lined, it would be February before the headline number would drop below 5%.
 
But if the Fed is executing policy to slow the rate-of-change in prices, the Fed should be concerned about the recent rate-of-change, not the change relative to last year's price. The recent data should give them information on whether or not their policies are working.
 
With that, if we look at the monthly change in prices, over the past three months, it has been tame. July was 0%. August was 0.1%. And September was 0.4%. That's a three-month average of 0.2%.
 
If you woke the Fed up today, and told them inflation was running at a 0.2% three-month average (annualized at less than 2.5%), they would be doing nothing with interest rates.
 

Pro Perspectives 10/31/22

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October 31, 2022
 
It’s Fed week.
 
We’ll hear from Jay Powell and company on Wednesday.
 
The market has priced in a 75 basis point hike.  That would bring the effective Fed Funds rate to just above 3.75%.
 
From there, the interest rate market is pricing in a coin flip chance between 50 bps and 75 bps at the December meeting. 
 
That could get the Fed Funds rate to 4.5%. 
 
Remember, it was their last meeting, in September, where they created the expectations for this, and did so through their “survey of economic projections” (SEP).  These are forecasts made on the economy, by each board member and each regional Fed President (total of 19 forecasts). 
 
Here’s a look at how these Fed officials presented the outlook in the September meeting…
 
Let’s focus on the Fed Funds rate projection (circled in yellow). This was revised UP a full percentage point.
 
That projected an additional 125 and 150 basis points of tightening by year end.  It’s that aggressive posturing by the Fed that sent the interest rate markets in an upward spiral (not just domestic markets, but global).
 
They went a step too far with the tough talk/ restrictive forward guidance. 
 
And with that, we found the uncle point for the global financial system.
 
The UK government bond market broke, and required a rescue from the Bank of England.  Stocks made new lows on the year.  The dollar made new highs on the year, and then the Bank of Japan was forced to intervene, to defend the value of the yen against a strong dollar (which is driven by the U.S. rate outlook). 
 
With all of this going on, both the Australian and Canadian central banks responded with smaller than expected rate hikes in their respective October meetings.  They balked. 
 
So, back to the Fed.  Given the exposed fragility in the global financial system to the current level of market interest rates, will the Fed pull the trigger on another 75 basis points this week?  Probably, but the treasury market has that rate increase more than priced-in (and consumer and mortgage rates do too, as they are based on treasury rates). 
 
The big questions:  Will the Fed acknowledge: 1) the rate sensitivity that has been exposed in the financial system, 2) the cooling inflation picture, and 3) the likelihood of a (less inflationary) fiscally conservative change in Congress coming?  Let’s hope so.  If so, the market will dial down (maybe dramatically) the rate outlook for December.  Rates will go lower, the dollar will go lower, stocks will go higher, the stability will improve.  
 
For perspective on just how “aggressive” the Fed talk is, versus what they really expect, let’s take a look at what the Fed’s long-run forecast for rates looks like now (in these Fed projections), relative to the past 10 years.
Notice that in the very low inflation environment of the past decade, where deflation remained a bigger risk than inflation, the Fed’s projection for the long-run level of the Fed Funds rate was not only higher, but much higher than the current long-run projection (which is just 2.5%).
 
Does this reveal the Fed’s true view, that after ballooning of government debt (globally) there is a very low ceiling on where rates can go (given debt servicing and financial system risk)?    

Pro Perspectives 10/31/22

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October 31, 2022
 
It’s Fed week.
 
We’ll hear from Jay Powell and company on Wednesday.
 
The market has priced in a 75 basis point hike.  That would bring the effective Fed Funds rate to just above 3.75%.
 
From there, the interest rate market is pricing in a coin flip chance between 50 bps and 75 bps at the December meeting. 
 
That could get the Fed Funds rate to 4.5%. 
 
Remember, it was their last meeting, in September, where they created the expectations for this, and did so through their “survey of economic projections” (SEP).  These are forecasts made on the economy, by each board member and each regional Fed President (total of 19 forecasts). 
 
Here’s a look at how these Fed officials presented the outlook in the September meeting…
 
Let’s focus on the Fed Funds rate projection (circled in yellow). This was revised UP a full percentage point.
 
That projected an additional 125 and 150 basis points of tightening by year end.  It’s that aggressive posturing by the Fed that sent the interest rate markets in an upward spiral (not just domestic markets, but global).
 
They went a step too far with the tough talk/ restrictive forward guidance. 
 
And with that, we found the uncle point for the global financial system.
 
The UK government bond market broke, and required a rescue from the Bank of England.  Stocks made new lows on the year.  The dollar made new highs on the year, and then the Bank of Japan was forced to intervene, to defend the value of the yen against a strong dollar (which is driven by the U.S. rate outlook). 
 
With all of this going on, both the Australian and Canadian central banks responded with smaller than expected rate hikes in their respective October meetings.  They balked. 
 
So, back to the Fed.  Given the exposed fragility in the global financial system to the current level of market interest rates, will the Fed pull the trigger on another 75 basis points this week?  Probably, but the treasury market has that rate increase more than priced-in (and consumer and mortgage rates do too, as they are based on treasury rates). 
 
The big questions:  Will the Fed acknowledge: 1) the rate sensitivity that has been exposed in the financial system, 2) the cooling inflation picture, and 3) the likelihood of a (less inflationary) fiscally conservative change in Congress coming?  Let’s hope so.  If so, the market will dial down (maybe dramatically) the rate outlook for December.  Rates will go lower, the dollar will go lower, stocks will go higher, the stability will improve.  
 
For perspective on just how “aggressive” the Fed talk is, versus what they really expect, let’s take a look at what the Fed’s long-run forecast for rates looks like now (in these Fed projections), relative to the past 10 years.
Notice that in the very low inflation environment of the past decade, where deflation remained a bigger risk than inflation, the Fed’s projection for the long-run level of the Fed Funds rate was not only higher, but much higher than the current long-run projection (which is just 2.5%).
 
Does this reveal the Fed’s true view, that after ballooning of government debt (globally) there is a very low ceiling on where rates can go (given debt servicing and financial system risk)?    

Pro Perspectives 10/28/22

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October 28, 2022
 
We finish the week with another big day for stocks. 
 
The bad earnings news from the tech giants has gotten a lot of media attention this week, but the earnings season for corporate America, overall, continues to be solid. 
 
We've now heard from over half of the companies in the benchmark blue-chip index (S&P), and over 70% have beat earnings estimates, growing earnings at 2.2% compared to Q3 of last year.  
 
As a reminder, heading into this earnings season, there was a lot of chatter about a big contraction in earnings (i.e. negative growth).  It hasn't happened.  
 
With that, and some intervention-induced stability in the financial system (BOE and BOJ), stocks are having a big bounce for the month — following a down 8% September, with an up 8% October.
As you can see in the chart, we end the week with a bullish technical break.
 
You can also see, the big force within this downtrend (denoted by the yellow trendline) has been the Fed, and the related inflation outlook.
 
On that note, it's important to remember what data drove the big 5% swing in stocks on October 13th (the bottom), which ultimately ended up 2% that day.
 
It was the September inflation report.
 
Why did stocks bounce? Because the hot spots in that inflation report (like new cars and rents) have been cooling (actually falling), but have yet to show up in the government's numbers.
 
Add that to the very tame inflation numbers over the prior three months, and we could be looking at a collapse in inflation by next year, as most of the effect of the 300 basis points of tightening has yet to be felt in the economy (still lagging). This, as the current level of market interest rates is proving to destabilize the financial system.
 
With all of this in mind, the Fed meets on Wednesday.
 
If they are paying attention, they should dial down the temperature in the interest rate market. Especially given the recent polling, that shows a likelihood of Congress flipping on November 8th.
 
In that scenario, the spigot on any additional fiscal spending would be closed. Moreover, the inflationary policies that have already been approved (including Build Back Better/IRA) would be challenged. If that plays out, the Fed would find themselves in a position where they have overtightened, already.
 

Pro Perspectives 10/27/22

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October 27, 2022
 
The Fed spent much of last year denying the obvious inflationary pandemic response from policymakers, and the subsequent evidence of that inflation.
 
That inflation denial by the Fed, gave the Democrat-controlled Congress the ammunition it needed to push through additional fiscal spending. 
 
Only AFTER Jerome Powell, the Fed Chair, secured a reappointment from Biden, did the Fed flip the switch and start talking about aggressively taming inflation. 
 
When that switch flipped for the interest rate outlook, it also flipped on the valuation of the high flying, high growth tech stocks.
 
Why?  As Warren Buffett once explained (my paraphrase), at zero interest rates into perpetuity, the valuation on the stock market is essentially infinite.   There are no alternatives.  Those that are required to earn a return (like pension funds), are forced to reach for return (by taking more risk).
 
Driven by this dynamic, the high return FAAMG stocks (Facebook, Amazon, Apple, Microsoft and Google), became the favored investment of the professional investment community — to such a degree that it represented nearly a quarter of the valuation of the S&P 500 at one point last year.   
 
But now we have interest rates.  Now there are alternatives. The Treasuries inflation bond is paying over 9%.  And as Wall Street analysts are plugging a much higher discount rate (interest rate) into their cash flow models, they are getting a lower price target (in some cases, much lower). 
 
This rising interest rate environment (especially from zero) is most damaging for growth stocks, which is why we entered the year expecting a transition in favor from growth stocks to value stocks. 
 
Indeed, if we look at the Vanguard Value ETF (VTV), it's outperforming the Growth ETF (VUG), down 8 percent vs. down 31 percent.
 
With that, we've looked at this chart many times in my daily notes, in anticipation of this shift from growth to value. 
 
As you can see, the last time value was this cheap, relative to growth stocks, value went on a nearly 10-year run of outperformance.
 
If you want to take full advantage of the tailwinds for value stocks, join us in my Billionaire's Portfolio subscription service.  You can invest alongside my portfolio, full of stocks with the potential to do multiples.  You can learn more here.  

Pro Perspectives 10/26/22

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October 26, 2022
 
Last Friday, the BOJ intervened in the currency markets (defending the value of the yen).  It turned the tide of markets that day:  stocks higher, yields lower, commodities higher and the dollar broadly lower. 
 
And that has become a trend this week. 
 
Importantly, we discussed the prospects that this intervention could mark a top in the dollar. 
 
That would be meaningful for commodities prices. 
 
And commodities prices have been on the move.  So have commodity stocks.  
 
Let's look at a few charts …
Above is the dollar index.  As you can see, the absolute top of this 20% rise in the dollar this year, was the day the Bank of England intervened to save the UK government bond market.  That reversed a free fall in the pound.  And then the BOJ was in, explicitly to stop the free fall in the yen. 
 
As we've discussed here in my daily notes, historically major turning points in markets come with some form of intervention.  Again, a turning point in the dollar, would mean a turning point in commodities. 
 
Remember, on Friday, we looked at the CRB index of broad commodities prices. 
 
Here's what that looks like now …
The trend in this young structural bull market in commodities is well intact.  And no coincidence, it started a month after the fiscal and monetary bazookas were fired in 2020 (inflationary policies). 
 
A bounce in commodities from this big trendline would align with a top in the dollar. 
 
What does that mean for oil prices?  Higher.  
 
This commodities/dollar relationship comes as the Biden administration's program to drawdown 180 million barrels of oil from the Strategic Petroleum Reserve has come to an end — as of yesterday!  This will remove the downward pressure on oil prices.  And the resumption of the move in oil will be coming from a high base of the mid $80s.

Pro Perspectives 10/25/22

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October 25, 2022
 
As we discussed yesterday, the biggest event for markets, by far, over the next two weeks, is the midterm election (bigger than earnings, bigger than the Fed rate decision).
 
With that, just a month ago, here in my daily note, we took a look at the election betting markets. The oddsmakers were pricing in about a 47% chance of a split Congress, and 33% chance of a Republican sweep.
 
Here's what it looks like now …
As you can see, the bets on a Republican sweep have ramped up since mid (late) September. 
 
What was happening at that time?  Markets were melting. 
 
If we could attribute a market timeline to this change in the midterm election outlook, it would start with a hot U.S. inflation number, then a warning on "worldwide recession" from FedEx, then a draconian message from the Fed on the rate path, then an attack on the Russia gas pipeline, then the meltdown in the UK bond market (a threat to global market stability), and then another hot U.S. inflation number.  Meanwhile, throughout this timeline, mortgage rates jumped from 6% to 7%. 
 
So, was it this destabilizing spiral, over the period of less than 30 days, that may outright flip control of Congress?  Maybe.
 
If so, the Republican Congress would likely go after (i.e. attempt to weaken) the Build Back Better funding (better known as the "Inflation Reduction Act")? 
 
That would be a catalyst to get yields moving back down. 

Pro Perspectives 10/24/22

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October 24, 2022
 
About a fifth of the companies in the S&P 500 have reported on Q3 earnings thus far.
 
Over seventy-percent have beat earnings estimates, and about seventy-percent have beat revenue estimates. And despite the hot inflation, profit margins remain healthy at 12%.  That's above the 5-year average.
 
These are reports from a quarter that the Atlanta Fed's GDP model is now projecting to have grown by an annual rate of almost 3% (that's AFTER effects of inflation).
 
Again, as we anticipated coming into these earnings, the fundamentals don't match the performance of the financial markets.  The fear is outweighing the facts.
 
On that note, no one has introduced more fear into markets over the past seven months than the Fed.  And we will hear from them again on November 2.  
 
But the bigger event for markets, and the economy, by far, comes in two weeks.  The midterm elections.
 
A Democrat White House and Democrat controlled Congress has led to executing of the full Democrat agenda, despite the fiscal and inflationary consequences.  On November 8th, we should get at least a split Congress.  This will bring gridlock, which will bring stability and certainty to the fiscal outlook. That's historically good for stocks.
 
In fact, post-midterm elections, regardless of the outcome, are historically good for stocks.
 
Bancorp did a study on this:  Looking back to 1962, stocks (S&P 500) in the 12-months following a midterm election had an average return of 16%.  That's double the long-term average return.  And over these fifteen data points observed (over 60 years), ALL had positive stock market performance for the twelve-month period following the midterm election.
 
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