Market Update - February 2023 | |
Here is my Dad-joke version of an inflation meme. Please forgive me. | |
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During January, the stock and bond markets rallied as tax-loss selling evaporated and investors started to get excited about the end of interest rate hikes from the Federal Reserve.
- Economic data continues to be mixed. GDP growth and employment are exhibiting positive data points, but there are other surveys and earnings reports are starkly negative. Intel Corp recently forecast a 40% decline in 1st quarter revenue!
- Our view is that stock market is in another bear market rally. The Fed is still raising rates, inflation is high, employment is strong and bad news is coming out slowly. Conversely, the slowing of the economy is pulling down inflation which should be bullish for bonds.
- This month's note covers data points that show some good news, but there is mostly bad news:
Good news:
- 2.9% US GDP growth in 4Q 2022.
- Consumer spending is strong.
- New Orders for all goods are strong in the US.
- Japan's Central Bank resumed quantitative easing.
Bad news:
- Reports on the broad economy indicate weakness.
- Reports on inflation, Fed policy and interest rates indicate higher rates.
- Weak earnings reports for the broad market, specific industries, and Intel Corp.
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Table 1: Market performance estimate as of 1/31/2023 (LIMW) | |
January 2023 was a risk-on month for all asset classes. Tax-loss selling leaned on the markets until late December, so the turn of the tax calendar meant that selling pressure eased dramatically. Additionally, after a relatively benign inflation reading mid-month, the media spent most of January talking about when the Fed would finish raising rates and begin cutting rates. In particular, the technology and emerging markets stocks performed quite well in January compared to their weakness in 2022. | |
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Despite the depressing bear market of 2022, there are some positive signs for the economy:
- 2.9% US GDP growth in 4Q 2022.
- Consumer spending is strong.
- New Orders for all goods are strong in the US.
- Japan's Central Bank resumed quantitative easing.
Let's discuss each of these in depth.
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2.9% US GDP growth in 4Q 2022 | |
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GDP growth in 4Q2022 came in with 2.9% growth. Even in the face of aggressive Federal Reserve (Fed) interest rate hikes, the broad economy continued to grow. In particular, inventories (+1.46%), exports (+0.56%) and government spending (0.64%) were major positive contributors to the quarter (source: WSJ).
In the chart below, we show the contribution of each GDP component by quarter: NX=net exports, INV=inventories, RESI=residential investment, GFCF=gross fixed capital formation, G=government, and C=consumer.
The latter half of 2022 was dramatically affected by inventory build and net exports. Inventory building may become a problem in 2023 if the consumer slows spending.
Figure 1: Components of US 4Q2022 GDP Growth (Institue for International Finance)
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Consumer spending is strong | |
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Consumer spending remains rock solid, as jobs are plentiful and many continue to borrow for important purchases. Remember, the service economy makes up 77% of GDP. Spending on basics such as health care, food, shelter, insurance, government and education continues in good times as well as bad. This regular activity is a good source of revenue for companies in this part of the economy. The service economy is slightly insulated from Federal Reserve actions to slow economic growth.
One look at a long-term trend in consumer spending tells the whole story (see below).
Figure 2: Consumer spending (WolfStreet.com)
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During the 2000 and 2008 recessions, sharp declines in New Orders for both durable and non-durable goods were confirming signals that recession had arrived. There is no evidence here that the economy is going off a cliff. However, during the mid-2010s, these indicators weakened significantly with no corresponding recession.
On the other hand, if the Fed is looking for economic weakness to pull down inflation, these signs of economic resiliency can be problematic. With the labor market tight, the Fed may need to do more to slow the economy to deal with inflation (in other words, raise rates higher).
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Figure 3: New Orders for durable and non-durable goods (LIWM) | |
Japan's central bank resumed quantitative easing | |
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Japan is now the second central bank to resume some form of quantitative easing to address their policy goals. You may remember that the Bank of England stepped into the bond market in October to halt a panicked liquidation of bonds by pension funds. They did this despite having inflation problems worse than ours right now.
Japan continues to pursue a strategy of controlling the interest rates to achieve their policy goals of higher growth and inflation. As we have seen across the world, inflation has risen dramatically and bond yields have followed them up. Japan has a peculiar problem: the central bank accepts the 3-4% inflation, but does not want to see 3-4% government bond yields. As a result, the government must step in and buy bonds to suppress the rise in yields (remember for bonds it is "price up = yields down").
This injection of cash into the financial markets spread globally and contributed to the rally in all financial assets (stocks, bonds and commodities) during January.
Figure 4: Global central bank liquidity actions (quantitative easing)
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There is quite of bit of bad news, both on an economy-wide and company-specific level. Let's group these data points into three broad categories:
- Reports on the broad economy.
- Reports on inflation, Fed policy and interest rates.
- Earnings reports for the broad market, specific industries, and Intel Corp.
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Federal Reserve regional activity indexes continue to decline | |
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Each month we pay close attention to the monthly activity indexes published by the Institute for Supply Management (ISM). This number reflects business activity across the broad economy. The February number will come out at 9:00 CST today.
Each Federal Reserve district publishes similar activity reports at various points during the month. To get some idea what the February ISM number is going to look like, we pulled each regional activity index to get an early look at the broad trend.
In general, the trend is down. In particular, the recent NY Federal Reserve district reading was one of the worst ever experienced (the NY Fed district covers NY, NJ and CN). There isn't much manufacturing here, but it is a very disappointing reading.
Figure 5: Regional Federal Reserve District Activity Indexes (LIWM)
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International PMI readings are similarly weak | |
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Economic weakness is not just a US phenomenon. All the developed economies are rapidly decelerating as they experience high inflation and higher interest rates. What is also interesting is that the service economies (US and UK) are slowing as much as the export economies (EU and Japan). This is a global slowdown.
Figure 6: Global PMI readings (Institute for International Finance)
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The "other" US Purchasing Manager Index | |
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There are two organizations that create broad purchasing manager indexes (PMIs) to reflect overall business activity. In the United States, the market watches the Institute for Supply Management's (ISM) PMI report quite closely. However, Standard & Poor's (S&P) publishes a similar PMI reading for each major country in the world. The key difference is that the ISM survey covers more companies in the United States than the S&P survey, while the S&P survey gives us a global snapshot using a consistent survey methodology for each country.
As analysts, we find this helpful because it provides a secondary method to observe our country's economic activity and compare it to other nations.
In January, the S&P PMI reading for the United States fell to 45. This is normally considered a confirmation of recessionary conditions, but as you can see with the good news data, it is not clear where we are on the recession-expansion spectrum.
Figure 7: Housing, S&P PMI, versus GDP growth (LIWM)
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Inflation weakens, but is still well above the Federal Funds rate | |
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Inflation continues to recede. This is good news because it implies the Fed will not have to raise rates significantly to halt the inflation cycle.
There is an ongoing debate about what inflation rate is the correct one to look at. Headline inflation, core inflation and core Personal Consumption (core PCE) inflation are each mentioned frequently in the press. In recent weeks, analysts have begun excluding annoying inflation numbers from rent and shelter to produce a new "super-core" inflation reading. You can't make this stuff up.
The goal of all this slicing and dicing is to give the Fed an excuse to halt rate hikes sooner and cut rates lower once we fall into recession. At this point, the whole debate has become highly politicized, so don't expect everyone to get what they want. Consumers want low, stable inflation and are ok with higher interest rates; this is anathema to Wall Street that wants zero interest rates and higher inflation.
Amazingly, there is still an enormous gap between headline inflation and Federal Funds interest rates.
Figure 8: Headline CPI, 10-year yields, and Federal Funds interest rates (LIWM)
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If history is any guide, the Fed will raise rates above inflation | |
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As we run through the negative data points, remember that these are key talking points and justifications for the Fed to start cutting rates now. However, unlike the economic cycles of the last 20 years, the shocking rise in inflation has changed the decision matrix for the Federal Reserve.
Does history give us any guide as to when the Fed will finish raising rates? Yes, it does. In general, the Fed will not finish raising rates until its policy rate is above headline CPI (consumer price index). If you look at the last chart in Figure 8, you can see we are 2.4% away from even getting to neutral using this metric. I am sure the Fed has been thinking a lot about the 1970s.
Figure 9: Market behavior after the first Fed rate cut in an easing cycle (Daily Shot@SoberLook)
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The end of Fed rate hikes is in sight | |
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One of the reasons this economic cycle is unique is that the Fed is trying to engineer a soft landing by finessing their rate hikes into a falling inflation environment. It is our view that as the economy decelerates, inflation will fall enough that the Fed will be able to cut interest rates.
Most analysts and the bond market are guessing this happens in late 2023 or 2024. Just remember that the rate cuts will be in response to an economic slowdown. We doubt inflation falls without economic weakness.
Figure 10: Short term Federal Funds rate forecast (Bank of America)
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Higher rates are creating broad weakness in corporate earnings | |
One of the key ways to measure economic health and the trend in general growth is to look at broad measurements of earnings. One of these data points is the aggregate earnings of the S&P 500. In other words, if we added up all the profits and losses of the S&P 500 and weighted them by the company's weight in the index, does that give us some idea how things are going? Yes, it does.
While not a leading indicator, tracking earnings estimates for the S&P 500 gives you a sense for the progression of an economic contraction or expansion. So far, the data indicates the peak in earnings occurred last year and now we are in the process of regular downgrades. In most recessions, broad earnings will fall 20-40%.
Why is this important? Because valuation arguments to buy the market "here" are useless while the earnings estimates are falling.
Figure 11: Earnings estimates by year (Goldman Sachs)
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Figure 12: 1-month Earnings Revisions look awful (this indicates analysts are busy marking down their estimates for 1Q2023) (Goldman Sachs) | |
Higher rates are killing housing | |
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The US economy is primarily a service economy with 77% of GDP associated with non-cyclical industries. However, it's the cyclical industries that make the economy oscillate in and out of recession and create conditions for markets to rise and fall.
This is why we focus on the cyclical impacts of Fed policy on the economy. It gives us tremendous insight into future earnings. In the following chart, do you see why following housing is so important? Housing tends to peak many months before the actual onset of recession making it a great leading indicator.
In the 4Q 2022, housing activity fell 27% from the prior year.
Figure 11: New home sales (Bill McBride, calculatedrisk.com)
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Other industries aren't looking that hot either | |
In addition to housing, semiconductors and cell phone markets are also showing remarkable weakness.
4Q 2022 semiconductor revenues fell 4% from 2021 with a clear peak in 2022. But the real kicker came from Intel's 1Q 2023 revenue forecast last week. Their $11 billion 1Q revenue forecast is 40% below that of 1Q 2022! I can't even begin to tell you how shocking this is. One analyst quipped: this isn't an earnings report, it's a crime scene.
Semiconductors are notoriously cyclical, so in one sense this forecast is not too shocking. On the other hand, it just seems like yesterday there was a semiconductor shortage and you could not get timely delivery of computers or monitors.
In the cellphone market there is a similar story of plummeting demand. 4Q 2022 demand for cellphone fell 18% fr0m 2021 levels. This is also an astounding report that has not received much press and may explain the significant weakness in Google and Apple.
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How this long analysis informs our investment strategy | |
Reviewing these data points gives us a firm grasp of the underlying fundamentals driving market behavior. Over short periods of time, the trading community can push markets up and down, but over long periods of time the fundamentals of profit, earnings and interest rates will inform the final destination of securities prices.
Our view is that we are still in a bear market, the economy is slowing significantly, the Fed will be raising rates at least one more time and the bear market lows are ahead of us.
Here is a helpful chart that shows the behavioral phases of bull and bear markets. Where do you think we are?
Figure 12: Hypothetical market cycle (Jean Paul Rodrigue, Hofstra)
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Everyone is bearish, but nobody is short | |
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One way traders express a bearish opinion on the market is by shorting stocks. This involves borrowing stock from the broker and selling it, hoping that it will fall in value to generate a profit. In trading, this is called a "short sale".
The mechanics are not important, but the following chart is. We've been in a bear market for over a year, yet nobody has been shorting the market. What this means is that investors are afraid to bet real money that the market can go down. This is another sign that investors have not capitulated in this bear market. Bearishness usually peaks at market bottoms and there is no sign of that now.
Figure 13: Short interest ratio on stocks and ETFs in the Russell 3000 (Bloomberg, Deutsche Bank Asset Allocation)
| Equity markets fall in stages | |
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Equity bear markets deteriorate from the edges and then move to the core. This means the most speculative sectors fall first, but eventually the large cap core of the market falls along with the rest. This is a general pattern across historical bear markets.
We can see in the following slide where we are on this timeline. Speculative asset classes like Bitcoin, initial public offerings (IPO), small caps and special purpose acquisition companies (SPAC) have all fallen much further than thought possible. For those who lived through 2000-2003 and 2007-2009, this should all look very familiar.
Figure 14: Risky asset class performance versus core S&P 500 (LIWM)
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The siren song of "value" stocks | |
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It must be a bear market because I hear an unending stream of value portfolio managers out on Bloomberg and CNBC talking about how great value does in a bear market. There is nothing wrong with the value investment approach and there are times when it does make sense.
However, let me show you how value investing has done in the last two recessions. It is our view that this is NOT a defensive investment strategy. It is only a different strategy.
Figure 15: Value benchmark performance versus the S&P 500 (LIWM)
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Current stock market commentary | |
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It seems like the current market rally beginning October 2022 should be a game changer. But if you look at the numbers, it is not as strong as the June-August 2022 rally. The market is running into stiff resistance from a variety of technical and economic factors.
However, the downtrend from January 2022 is clearly broken, so this is a significant positive development for the equity market.
We have an important Fed meeting this week that will set the market tone for the next few months. Markets are expecting a 25 bps rate hike and a discussion about when rate hikes will end.
This is important because the longer and higher the Fed hikes rates, the deeper and longer the imminent recession. There is an important battle taking place behind the scenes between those who want to fight inflation and those who want to promote growth.
Figure 16: Current bear market (LIWM)
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In bear markets counter-trend rallies can be spectacular and give investors hope that the pain will soon end. We know from other difficult bear markets that this is frequently not the case.
For examle, here is what bear market rallies looked like in the 2000-2003 bear market.
Figure 17: 2000-2003 S&P 500 bear market (LIWM)
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Our 2022 performance (as of 12/31/2022) | |
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Our recent out-performance was driven by two key decisions in late 2021:
- Underweight equities
- Overweight short-duration Treasuries and Floating Rate debt.
These two decisions allowed us to miss most of the pain from equity and bond market weakness. Our performance disclosures are down below.
Please note that the Month-to-Date (MTD) column here describes performance through December 2022, not January 2023 as in Table 1. Similarly, the Year-to-Date column is for all of 2022.
Table 2: Lloyds Intrepid Wealth Management performance as of 12/31/2022
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This is a very busy week for the markets.
1) Three important central banks are meeting this week: the US Federal Reserve, Bank of England and Bank of Japan.
2) 35% of the companies in the S&P 500 report earnings this week; Apple, Amazon, Starbucks and Qualcomm report Thursday evening.
3) February 1st gives us PMI readings from around the world.
4) February 3rd gives us the latest Payrolls report.
We are in the midst of a difficult bear market. The Fed is still raising rates, inflation is high, earnings weakness is accelerating, and employment remains strong. We expect the Fed to continue raising rates to 5%, which will eventually trigger negative side-effects in the stock markets and economy. Conversely, this will be positive for the investment grade bond markets.
We remain underweight equities heading into 2023 and overweight investment grade bonds. Yields are falling as the economy slides into recession. The current bear market rally is getting stale, and the Fed is unlikely to back off their tightening policy in coming months.
If you are concerned about your situation and would like to speak with us, please reach out to us at the phone numbers below.
We look forward to hearing from you!
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
| Lloyds Intrepid LLC is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from Lloyds Intrepid LLC with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis. | |
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Performance Disclosures
INVESTING INVOLVES RISK, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS.
NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE.
Lloyds Intrepid LLC is doing business as Lloyds Intrepid Wealth Management. Lloyds Intrepid LLC offers investment advisory ser-vices and is a registered investment adviser in the State of Texas where registered and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. Lloyds Intrepid LLC and its advisers do not provide legal, tax or ac-counting advice. Lloyds Intrepid LLC formulates retirement plans, investment strategies, portfolio construction and investment due diligence for clients with signed investment advisory agreements with us.
This presentation is offered for informational purposes only and is not a specific offer or solicitation by Lloyds Intrepid LLC to buy or sell any investment product or service. This presentation is not investment advice. All opinions and outlooks are subject to change. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. Investments possess a variety of risks. Equity securities possess more risk than bonds or other debt securities and are particularly subject to fundamental change as well as changes to economic, legal, regulatory, and monetary policy, both in the U.S. and abroad. Smaller and international equities have more risk than large US stocks. Bonds are subject to credit risk, interest rate risk, inflation risk and default risk. Treasury bonds tend to have little credit and default risk but are highly sensitive to changes in interest rates and inflation. Corporate bonds tend to be more sensitive to credit risk and default risk. Municipal bonds typically pay tax exempt interest and despite being government entities are subject to credit risk, interest rate risk, inflation risk and default risk. Mortgage bonds possess credit risks and prepayment risks not found in other bond categories. In-vestments in real estate are subject to interest rate, default, and economic risk. International investments, either through direct investment, ADRs or funds, possess unique risks associated with currency translation, different accounting standards, and legal risk from operating in a foreign jurisdiction. Commodities possess unique risks that include regulatory risk, high price-volatility risk, along with interest rate risk, inflation risk and credit risk. Portfolio strategies that use asset allocation, diversification, re-balancing, indexing, or security selection do not ensure profit gains or loss avoidance. Indexes are unmanaged and not available for direct investment; index fund performance will differ from index performance due to management fees. Losses will likely occur in declining markets.
This performance report is generated from the returns of actual portfolios. Composites represent actual portfolios that are managed together in a single discretionary strategy. Lloyds Intrepid LLC performance has not been independently verified. All advisory fees, commissions and client paid expenses are reflected in this net-of-fees presentation. Some portfolios are portfolios that pay no fee and have less than $10,000 of value. These will be disclosed if requested. There are no material factors for comparing returns to benchmarks; each strategy is matched with an appropriate benchmark for comparison. Strategies presented reflect the performance of Lloyds Intrepid LLC discretionary portfolios. Investment objectives are consistent with the assigned benchmarks.
These portfolios have a potential for losses as well as gains. Returns are presented net-of-fees. Risk measures, when presented, are calculated gross-of-fees. Performance is reported in U.S. Dollars. Composites exclude portfolios that have changed model during the measuring period. Internal dispersion is not presented for composites with less than five portfolios. Dividends are included in portfolio return. Investments cannot be made directly into an index.
Lloyds Intrepid LLC offers discretionary portfolios where holdings and asset allocations are actively managed. Unless noted otherwise, these strategies do not use leverage, derivatives, or short positions, are generally liquid and carry the risks associated with index, mutual fund and exchange-traded-fund investing. Occasionally, these strategies will hold individual stocks. The investment objective for each strategy is to exceed the long-term performance of the associated benchmark. Here is a list of our strategies:
Bonds
Bond portfolios target an asset allocation of 99% bonds.
Conservative
Conservative Portfolios target an asset allocation of 25% stocks and 75% bonds and cash.
Moderate Conservative
Moderate Conservative portfolios target an asset allocation of 37% stocks and 63% bonds and cash.
Moderate
Moderate portfolios target an asset allocation of 50% stocks and 50% bonds and cash.
Moderate Aggressive
Moderate Aggressive portfolios target an asset allocation of 63% stocks and 37% bonds and cash.
Aggressive
Aggressive portfolios utilize an asset allocation target of 75% stocks and 25% bonds and cash.
Stocks
Stock portfolios target an asset allocation target of 99% stocks.
Blended benchmarks are custom benchmarks that are applied to the performance of each named composite and reflect the long-term asset allocation target for each strategy. The composites presented here are those where LIWM has complete portfolio and asset allocation discretion.
Bond composite benchmark is 100% Bloomberg Barclays Aggregate Bond. The Bloomberg Barclays Aggregate Bond benchmark is used in the blended benchmarks below.
Stock composite benchmark is 100% S&P 500 total return. The S&P 500 benchmark is used in the blended benchmarks below.
Conservative composite blended benchmark is 25% stocks and 75% bonds.
Moderate Conservative composite blended benchmark is 37% stocks and 63% bonds.
Moderate composite blended benchmark is 50% stocks and 50% bonds.
Moderate Aggressive composite blended benchmark is 63% stocks and 37% bonds.
Aggressive composite blended benchmark is 75% stocks and 25% bonds.
While returns are presented here as net-of-fees, gross-of-fees returns are available for institutional investors on request and reflect the deduction of transaction costs and custodian fees but not the deduction of investment management fees.
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