Last week we said there was a transition happening and briefly discussed what to expect in the second quarter. Now we’re starting earnings season, which will be led by the money center banks (how appropriate), and we at Cornerstone want to look beyond the noise through the end of 2023.
Remember that nothing cures market ills like rising corporate profits. “Earnings fixes everything.” Multiple times this year, bullish investors have tried to sustain upward momentum only for those attempts to be thwarted by warm inflation readings, giving the Federal Reserve cause for hawkish interest rate bumps.
Just over a week ago, new employment data caused federal funds rate futures to price in a nearly 70% chance of another 25-basis-point hike by the Fed in May. Although the job gains were the lowest on record since December 2020, the Fed will probably still increase rates once more. Also, Americans filed an additional 142,000 first-time unemployment claims (up 24% from previous levels).
This information fueled bears and speculation that a recession is near. Therefore, earnings season is the next big hurdle.
Bears also highlight the recent sharp decline in commercial and industrial loans, as well as deposits exiting the banking system in favor of money market funds. This is due to the recent bank failures.
To put this into perspective, the Fed released the H.8 report, which outlines assets and liabilities of commercial banks, showing a two-week drop of $68 billion. This data indicates a tightening of economic activity that the Fed could never obtain on their own through rate hikes.
The bears would argue that equity markets are misleading currently and not as strong under the surface as they seem. They negate the S&P 500’s gains because mega-cap technology stocks, like Apple* and Microsoft* are fueling the rise. There’s a big lag between the equal weight S&P 500 and the market cap S&P 500:
Such negativity, especially the clear increase in layoffs, won’t stop the Fed from raising rates again. But the warning is worth following. Also worth observing is that the federal funds rate of 4.9% is greater than the core personal consumption expenditures price index (PCE) rate of 4.6% (core PCE is the Fed’s preferred inflation gauge). Economists often mention that if the interest rate is more than the core PCE rate, tightening policy work is done (more on this in a bit).
This bearish fodder has reinvigorated recession talk. The recent dramatic decrease in first quarter gross domestic product (GDP) expectations published by the Federal Reserve Bank of Atlanta, which now forecasts only 1.5% growth in GDP (down from 3.5% two weeks ago) does too:
A note to the Fed: PLEASE STOP BEFORE YOU BREAK SOMETHING ELSE! A similar message is emanating from 10-year Treasury yields, which continue to decline (see below). The bond market is essentially daring the Fed to raise rates further and saying the central bank will need to cut later.
But the market knows all this already and priced it in (hence the sideways action). This news isn’t new.
What Does the Market Not Know?
We think the market has held ground because the tightening cycle is nearing its end. At some point the Fed will need to pump liquidity into the banking system to backstop deposits.
What’s unclear as of now is what earnings season will deliver in the way of profits and guidance. Only projections exist as of this writing – FactSet forecasts first quarter earnings to decline by 6.8%:
However, FactSet was slightly too bearish last quarter when earnings were not as bad as feared. Will history repeat itself?
As of March 24, 106 S&P 500 companies issued pre-announcement earnings-per-share guidance for the first quarter of 2023 with 78 of them issuing negative guidance, per FactSet. It’s the most since 2019:
Still, the S&P 500 and Nasdaq composite haven’t caved. If all the bearishness can’t crush indexes, perhaps the earnings recession is already happening and will run its course by summer. That would signal a rebound in the latter half of the year. Assuming inflation has peaked (and will continue to decline), and earnings are troughing, it makes for an interesting setup.
What does that mean?
Well, it might mean Wall Street loves “goldilocks” scenarios that are neither too hot nor too cold. In other words, investors like strong growth that creates jobs and profits, but doesn’t produce inflation.
Yes, growth has slowed. But there isn’t profound contraction. And despite the Fed’s recent claims, we think a deep, earnings-bruising recession is still unlikely. Sure, GDP estimates have shrunk. But a federal funds rate of 4.9% and a core PCE rate of 4.6% should signal the Fed’s work on inflation is worth a pause.
Thus, we think we’re at an inflection point (as we’ve said would happen in the second quarter). The right side of this chart agrees:
Bears point to the commercial and industrial loan data, with tighter credit aiming to torpedo the economy and earnings. However, the Bloomberg Financial Conditions Index, which tracks the overall stress level in U.S. money, bond, and equity markets to assess the availability and cost of credit, isn’t going crazy. For context, the index hit -6 in spring 2020. Now it’s -0.4, which is near the 20-year average and down from 0.3, which is when banks began cratering:
Why is this a possible upshot for stocks, looking nine to 12 months out? Because the regional bank failures seem to be a wash, making the Fed more likely to stop tightening sooner. That will help blunt the impact of weaker lending on the broader economy. Plus, any anticipated slowing of growth can be neutralized by Fed easing later in the year.
Historically, stocks tend to do well after the Fed stops increasing rates because markets look forward. Investors are buying in anticipation of faster future economic and earnings growth as the drag from rising capital costs is replaced by stimulative cheaper money.
History also tells us that it doesn't usually take the central bank long to shift gears from hikes to cuts – it runs to get the glue immediately after breaking things:
Since 1957, the Fed has only waited an average of 3.4 months between rate hikes and beginning to ease policy. It's just a matter of time before the Fed begins easing again, which is why the 10-year Treasury has been in a downward spiral since the banking crisis.
Now, 1957 isn’t the most current data. More recently, since 1989 the average time for the Fed to cut rates after raising them is 7.8 months. So, if the last rate hike is in May, 7.8 months takes us to the middle of December – just as our base thesis indicates.
Current earnings expectations are low. Weak results have already been priced into stocks. Earnings jitters largely explain last year’s sideways market. That’s why we expect another “better than feared” round of earnings and forward guidance, leaving bears frustrated again.
Price action, which is most important, shows an upward bias. So, investors are looking beyond current market shortcomings to see the bigger picture down the road.
*Links to third-party websites are being provided for informational purposes only. CoreCap is not affiliated with and does not endorse, authorize, or sponsor any of the listed websites or their respective sponsors. CoreCap is not responsible for the content of any third-party website or the collection or use of information regarding any websites users and/or members.
*Cornerstone Financial Services, LLC owns Apple (AAPL) and Microsoft (MSFT) directly in managed accounts. Daniel Milan also owns them personally.
Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial and CoreCap are separate and unaffiliated entities.