February 2023 Market Update

The market expects the Federal Reserve to raise 25 basis points at the February 1st FOMC meeting. The Fed is likely to continue to tighten monetary policy against a backdrop of a deteriorating economy in order to achieve price stability. This will likely lead to recession in 2023. Leading economic indicators have been signaling further deterioration in the economy.

For the month of December, the ISM Manufacturing index printed at 48.4, down from the November reading of 49. Manufacturing new orders also dropped to 45.2 vs the previous month's 47.2. The NAHB (National Association Homebuilders) index for January printed at 41, which is up from the December reading of 35. In addition, the Chicago PMI printed 44.9 for the month of December, up from November’s 37.2. While leading economic indicators continue to deteriorate, and some as mentioned above are already in contraction territory, mixed signals are being given from the strength of labor market data.

The unemployment rate, which is a lagging economic indicator, printed at 3.5% for the month of December, down from 3.7% in the month of November. This data may appear strong for now, but keep in mind that not only is this a lagging indicator, but the employment situation continues to deteriorate via leading economic indicators such as, falling number of hours worked, housing starts and a rising trend in continuing jobless claims.

The employment picture is deteriorating. Based on economic data the business cycle is likely to reach the final stage of the cycle. Shown below is leading economic indicator, housing starts, year over year vs lagging economic indicator, unemployment rate, year over year.

Leading Economic Indicators: Housing Starts: single family units vs 4-week moving average of continued claims 1969-today. Shaded areas are recessions. During recessionary periods the U.S. Bond market pays investors as the asset class acts as a hedge against a weakening economy.

The bond market agrees with the leading economic data. With the 10-2’s spread still extremely negative the 2 year yield typically front runs the Feds rate hikes. However, since the last Fed rate hike to 4.25-4.5% at the December meeting, instead of the 2 year rising ahead of the federal funds rate, the 2 year yield is now inverted with the federal funds rate and is bouncing along support at 4%. This is an imminent sign of recession and a warning signal for market participants expecting the continuation of strong labor market conditions.

So far this year the market has been led by the China reopening narrative. Many investors became economically bullish on the global economy when the Chinese economy reopened in November. This has led copper, gold and mining and US homebuilding stocks to technical breakouts in the near term induced by a rising eurodollar and falling mortgage rates. While a move down in nominal interest rates resulting in falling US mortgage rates is consistent with declining growth, we do not view this as economically positive and is likely the beginning of witnessing the bond market react to demand destruction and falling growth. For these reasons we feel betting on emerging markets and Chinese equities to lead global growth while the U.S. and European economies fight inflation and deal with economic war, is directly fighting the Fed.

For equity rallies to be sustainable they need to be accompanied by improving economic and earnings data. Chicago PMI data, which is highly correlated to and leads earnings data, suggests further weakness ahead for S&P500 profit margins and growth.

The S&P500 is currently valued at 19.1x next year’s earnings, which are at $210. (19.1 x $210) for the price of 4011. Since our January market update the S&P500’s earnings estimate revisions for 2023 are lower by -6.7% from $225 down to $210 and the price is higher by +6.1% from 3780 to 4011. The PE value increased from 16.8x to 19.1x with declining earnings. This is not a deal.

We believe earnings estimates are still overstated based on economic weakness from the business cycle. The $210 earnings forecast for 2023 is still too high and the PE multiple is also too high at 19.1x. Even though earnings estimates have been cut by -6.7% since the beginning of 2023, we believe another -13% of cuts down to approximately $180 is on the way. Using the 2022 low PE of (16 x $180) in earnings brings us a more reasonable valuation for the S&P500 near 2880. Combining fundamental and technical data together suggests the S&P500 should find support near the 3050 area. Keep in mind that if we take the historical average recessionary PE (price to earnings ratio) of 13.5 (13.5 x $180) then 2,430 is the output.

We believe the earnings recession for the S&P500 will bottom with earnings estimate revisions moving from decreasing at an increasing rate to decreasing at a decreasing rate. Which means the rate of change has formed a new trend in the earnings data. We currently believe that will occur near the S&P500 3,050 level. Ultimately, a recession cannot peak until credit spreads have peaked, unemployment has peaked, and earnings estimate revision data has bottomed.

Q4 GDP reading came in at 2.9%. The report shows inventory growing while masking economic weakness. Inventories accounted for 1.4% of the 2.9% GDP print. Companies working off inventory will weigh on new orders and growth. Large integrated oil and gas companies have refrained from increasing capital expenditures and instead have opted for buybacks as the best strategy for their savings. Oil and Gas companies do not appear to believe the notion that the economy will improve from here. We feel oil prices will test $60 a barrel and may even reach mid $40’s during the peak of a potential recession.

Market participants chasing the value and price of the stock market higher amidst a deteriorating economic outlook may ultimately find themselves disappointed at their decision making. There are high hopes placed for a Fed pivot. We feel the shock to the market’s valuation will finally come when the consensus no longer expects the Fed to pivot. We expect The Fed to make very clear their intention of holding rates in restrictive territory for a considerable period and for that weight on profit margins and growth expectations to crack asset valuations.

We continue to expect the yield curve to re steepen and for economic and market deterioration to bring about cheap asset valuations and force Fed policy change. We do not expect the Fed to pivot or policy change until at the very least their 4.5% unemployment rate target for 2023 is breached. Until then pivot is not on the clock. Potential recession and re steepening of the yield curve are. Which is why we believe investors will continue being rewarded with risk-free interest and cash. The U.S. bond market pays investors to wait and acts as a hedge against falling employment and growth during economic downturns.

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