This summer we likely will have resolution on three key issues, ranked below in order of importance, that will “unstuck” markets higher or lower:
1. Hard/Soft landing. 2. Inflation. 3. Fed policy.
If there’s a hard landing, then stocks can drop, a lot, from current levels. If there’s stagflation, stocks can drop, a lot, from current levels. And, with so much money on the sidelines, if the Fed sticks the soft landing, then stocks can rally, a lot, as investors chase markets higher.
Core inflation needs to track below 5.0% y/y by the end of the summer (and the closer to 4.0% y/y, the better). If that happens, it’s positive for stocks, long-dated bonds, growth/tech, and commodities, negative for the U.S. dollar. If that doesn’t happen, it’s negative for stocks and bonds, should lead to relative outperformance from defensives and low vol ETFs, commodities, and positive US Dollar.
Despite 73% of corporations beating explectations in the first quarter, corporate profits declined 5.1% in the first quarter of 2023, the fastest drop for any quarter since 2020 during the early days of COVID. As some analysts have pointed out, the drop appears to be driven by large and unprecedented losses at the Federal Reserve, a result of the Fed paying banks higher interest rates for them to hold reserves, combined with the Fed’s massive balance sheet.
But appearances can be deceiving. Yes, the Fed is losing more money than ever before, but those losses are due to payments to banks that should lift those banks’ profits. And despite that boost to banks’ profits, economy-wide profits excluding the Fed’s losses were still down 2.7% in Q1.
Using a 10-year Treasury yield of 3.8% (the Friday close) to discount profits suggests the S&P 500 index is fairly valued at about 3,500, well below the Friday close of 4,205.
I am not trying to say the economy is already in a recession. Recent figures show the job market is still holding up and consumer spending is still expanding. What we are trying to do is show that we are not out of the woods regarding recession risk, not by a long shot.
We are not often pessimistic about equities and think the long-term is still bright. However, we think there are still problems ahead in the near term and investors need to be prepared. As a result, we will maintain our defensive posture on stocks for the next couple of months.
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