Dear Investors,
Profits cycle update
If the Fed remains committed to bringing inflation down to its 2% target, U.S. nonfinancial corporate profits are likely in the early stages of a multiyear decline, according to Bank of America.
For one, top-line growth tracks nominal gross domestic product (GDP), and a committed Fed means inflation would fall at the same time real growth is already running well below trend.
Second, the stimulus-boosted level of profits is well above the long-term trend and tends to decline to trend (or below) during a recession.
In the meantime, historical analysis suggests Equities often show resilience in the early stages of a profits decline (as they are now) but eventually give way once a recession is imminent.
Economy wide profits tend to decline more than 20% from peak-to-recession-trough
During the 2008/2009 Great Financial Crisis (GFC) and the tech bubble of 2001, the downtrend lasted multiple years and exceeded -40%.
The decline tends to last for at least two years, suggesting profits move lower well into 2024.
At current levels, a return to trend would imply around 40% downside risk over the next few years.
S&P 500 operating earnings tend to decline 30% to 40% in a recession, but consensus S&P 500 operating earnings still have YoY growth in the double digits in 2023-2024, according to data from S&P.
This is not unusual, as earnings misses have a cyclical tendency.
Applied Global Macro Research have noted that the level of the Institute for Supply Management (ISM) (46.2%) combined with year-ago earnings estimates of $250 per share implies that earnings have downside risk relative to consensus.
The FED is reaching the peak policy rate
For Pictet Wealth Management the Fed is very close to reaching peak policy rate. It remains a close call whether the FOMC will hike rates by 25bps or pause in May.
The decision will come down to whether officials place more emphasis on solid, but lagging, fundamental economic data, or deteriorating, but leading, credit condition signals.
Given the long and variable lags of policy tightening, it may be prudent for the Fed to wait and assess.
Either way, if the Fed hikes in May, we believe it is going to be the last one this tightening cycle.
Importantly, Pictet Wealth Management expects the Fed to hold rates at its peak level this year and don’t see rate cuts until 2024.
Despite our projected recession, inflation is likely to remain way above 2% this year, putting a high hurdle for the Fed to cut.
Inflation fight not over
Inflation in the U.S. is not on track to settle anywhere close to the Federal Reserve’s 2% target, according to BlackRock.
That was reinforced by March inflation data published last week.
That showed underlying inflation pressures are increasing rather than subsiding.
After a short and bumpy spell of goods prices falling – which was key to overall core inflation declining from its highs last year – core goods inflation is rising again.
And core services inflation excluding shelter accelerated to 4.8% on a three-month annualized basis, up from 4.4%. See the orange line on the chart.
At that pace, and with goods inflation moving the wrong way, overall core inflation is set to settle close to 4% – see the yellow line.
BlackRock thinks that increases the odds of the Fed hiking rates again next month, but more importantly, does not provide any basis for markets’ hopes that the Fed will come to the economy’s rescue with rate cuts later this year.
Explore our recent Macro take blog posts.
Living with Inflation
High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes.
Yet there has been little debate about the damage to growth and jobs.
“Politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view.
BlackRock thinks we are going to be living with inflation.
They do see inflation cooling as spending patterns normalize and energy prices relent.
The beginning of the end of the fed tightening cycle and future equity returns
Forecasting the federal funds rate is fraught with risk and uncertainty – even in times of relative calm and tranquility.
That said, after lifting rates over the past year at a pace not seen in decades, and with both inflation and final demand trending lower, the end of the Fed tightening cycle is approaching.
We are at the beginning of the end.
What FED funds futures are telling us?
Fed funds futures show that the market is pricing in at least 50 basis points (bps) of cuts in the fed funds rate by the end of 2023. That may be premature and aggressive, in our opinion.
The consensus is that after another rate hike in May (25 bps), the Fed hits the pause button for the remainder of the year and begins to cut rates starting in 2024.
Should this scenario play out, the chat gives us some direction/guidance as to what to expect for S&P market returns once the fed funds rate reaches its cyclical peak.
In a nutshell, and on average, post-peak rallies in Equities are solid as concerns of rising interest rates fade, economic activity bottoms out, earnings momentum resets, valuations and the risk premium become more attractive, and investors reposition capital toward risker assets.
US Economic growth update
US economic growth has proved to be much more resilient to higher interest rates, energy and other input costs than many expected, as the rundown of savings built up during the Covid period and release of pent-up demand has supported consumer demand – particularly for services.
GDP growth came in at a healthy 2.6% in Q4 2022 and is tracking around 1.6% in Q1 2023.
Economy’s resilience
The big question going forward is whether the Is US economy’s resilience to higher rates and recent bank and financial volatility is sustainable or if the impact is just delayed.
ICG suspects the effects of financial tightening will become much more evident in the coming quarters, with cyclical and interest rate sensitive sectors coming under pressure.
However, with employment markets still healthy relative to previous cycles and consumer balance sheets still strong, barring a much larger domestic or external shock, they think the slowdown remain highly sector focused, and a broader deep recession is likely to be avoided.