July 2023 Market Update

At the July FOMC meeting the committee voted to raise interest rates an additional 25 basis points to a new target range of 5.25%-5.50%. Chairman Powell pointed to core inflation and the labor market for reasoning behind the decision. The Federal Reserve’s goal is to eliminate any risks of intrenched inflation so to prevent the worst of all outcomes for the U.S. economy and the middle class.

Since April, Consumer price index (CPi) figures continue to drop sharply from 4.9% down to 3% for the June reading published in July. Core inflation numbers have come down over the last few months from 5.5% to 4.8%, but the concern is that core inflation is not dropping fast enough and still above most maturity spots on the yield curve. With the 10-year yield trading right around 4% and the 30 year slightly above 4%, it is important that the core inflation rate falls below the current maturity rates on the yield curve. If they do not and core inflation remains sticky, then the Fed may be forced to raise interest rates even further, impacting consumers even more.

Meanwhile, as the market waits for restrictive Fed policy to impact the labor market, retail sales, gross domestic income and total business sales figures continue to decline. This data along with many other leading economic indicators suggest a recession has potentially already started and markets are still waiting to feel the long and variable lags of restrictive Fed policy to create a meaningful economic impact.

For the month of June, the ISM manufacturing data recorded yet another miss of expectations and a decline to a level of 46, its seventh straight decline and the lowest level since May of 2020. The economy is deteriorating. Chicago PMi, a highly correlated indicator to S&P500 earnings strength recorded at 41.5 vs an expectation of 44.6 for the month of June. Since April the ISM manufacturing index has fallen from 48.6 to 40.4 in May and bounced up to 41.5 in June.

This data is in contraction territory below 50 and while the market cheers as inflation declines and speculates on oil and other commodity prices, it would not shock us to see an unsustainable very short-term bounce in ISM manufacturing and Chicago PMI data. It is in our view that any increase in commodities, oil prices and inflation expectations will likely negatively impact retail sales and total business sales further and ultimately lead to a harder landing for the consumer and the overall economy.

With regard to the direction of economic and earnings growth we believe the horse has left the barn. In our view, the Federal Reserve holding rates in restrictive territory at 5.25%-5.50% will eventually prove the current assumptions for 2024 and 2025 S&P500 earnings estimates far too optimistic.

We do not believe that estimates of $250 in earnings for 2024 and $270 in earnings for 2025 will hold for much longer and expect by September/October Wall Street analysts will revise these numbers lower. It would make logical sense that along with those S&P500 earnings estimates beginning to come down that core inflation data also begins to break down. Barring of course any geopolitical surprises from China or Russia.

The message we want to deliver is, do not fight the fed while also mistaking short term price swings for renewed economic growth and inflation forecasts. The market’s performance follows the direction of profitability, we are not interested in paying up for a market with deteriorating earnings expectations and profitability.

For these reasons we do not recommend chasing the S&P500 index here at 4575. We understand the allure of owning and chasing stocks seems much more exciting than accepting the 4.50%-5.50% investors can earn with the federal funds rate at 5.25%-5.50%.

Our job is to predict forward profitability in order to determine future value and make sound sustainable investments. We believe that patience will be highly rewarded and that the opportunity to buy high quality businesses with strong cash flows at a discount will be grand.

There will be an event or a catalyst that will shock the system. It could be any number of things. But when it happens, the valuation readjustment will be fast. Manage your risk and prepare your portfolio to endure a recession.

With the S&P 500 trading around 4575, at approximately 22.7x earnings, we continue to believe investors will be rewarded by being positioned defensive, risk off and in cash, short term interest rates, 0–5-year U.S. Treasury bills and notes, money market funds, 10-year minus 2-year yield curve re steepening and select low duration equities.

Disclosure

Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.

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