A Fear of ‘Higher for Longer’ Interest Rates from the Fed

Jeff B (00:00):

Hello everyone, and welcome to the latest edition of LPL Market Signals. Jeff Buchbinder here, your host for this week, back from vacation with my friend and colleague, Dr. Jeffrey Roach. How are you today, sir?

Jeff R (00:14):

Doing great. Always glad that you can take a vacation, but we're always glad when you come back. So glad you're, glad you're back.

Jeff B (00:23):

It's nice to be wanted and welcome back. I got to say, though, we're, we're recording this Monday afternoon, February 27th. I am dragging a little bit. I came in on Monday morning with just a burst of energy, ready to go, happy to be back and you know, after a real busy day, you know, and a full week on the beach that the energy is starting to go. So you're going to have to bring us up a notch, Jeff.

Jeff R (00:49):

Yeah, we'll do it. We'll do it. We do start early around here. I think that's the key, right? We start way before the markets open up, let me tell you that.

Jeff B (00:57):

Oh, we sure do. We sure do. Anything to help the LPL advisors and all of our friends out there clients, investors the general public. We're  certainly here to help them. We love what we do. So here's our agenda for today. We're going to talk about certainly last week's market action, which we always do. Pulled out a few themes from last week. You know,  the biggest headline was just the hot inflation number that has caused the market to ratchet up expectations for Fed rate hikes. But we also saw some weakness in mega cap growth stocks that I think  is worth pointing out. And you know, and then coupled with the Fed fears, you did have you know, move higher in the 10-year yield. And as interest rates rise, bonds become more competitive against stocks.

Jeff B (01:53):

Future earnings become less valuable in today's you know, in today's value. And you know, you end up with a down week. So we did see a down week and although maybe got a little bit of that back here Monday right at the close. So that's the first part of the agenda. Then we'll talk about the debt ceiling, which is getting a lot of attention. We've been getting a lot of questions about just how that's going to play out. So we'll cover that. And then Jeff, you have a comment  on the services economy, which is, you know, kind of uplifting, you know, after the market's down, it's, you know, hard to be uplifting, but which it certainly was down last week. But there's still some good news here amid all of the recession fears, and that is that you know, the services economy does have some upside, and then we'll close it out as we always do with a preview of the week ahead.

Jeff B (02:51):

So here are recent returns, you know, just focusing on that one week column. There, you see the S&P 500 down almost 3% last week. So, you know, not only the worst week of the year it was, you know,  the worst week we've seen since early December. And  I think it really boils down to just more fears of more rate hikes. It's as simple as that, you know, the returns didn't really get any better if you looked overseas generally. So, you know, it was just kind of a, I don't know, a global, a global selloff. Jeff, have I tried to pull a positive out of this though? We are still up year to date, and so coming into this year, if you'd said, you know, we're going to add a couple of Fed rate hikes to market expectations, and yet the stock market would be up, I don't know if I would've believed that. What do you think?

Jeff R (03:50):

Yeah,  I think it still fits with our bigger 2023 narrative that things will be choppy now as the consumer kind of retools, recalibrates, reassesses. And then, you know, the latter half of the year, particularly Q4, you know, a lot of the headwinds that we still see and the uncertainties that we still have may be behind us. So, you know, the first part's going to be a lot different than the latter half. You know, we're going to talk about the debt ceiling in a little bit, that really plays into this idea of choppiness in the first part and a little bit better latter half. You know, we're going to talk a little bit about Fed expectations. You know, thinking about internationals as well, Jeff, to your question, you know,  with the moves last week about the fact that, you know, the Fed actually might hike higher for longer, you know, that's actually not just a U.S. problem, that investors are kind of getting their hands wrapped around. It's really a global thing. So for example, you know, as you mentioned, we're recording here on the 27th and earlier today, the 10-year German bond traded at the highest yield since 2011. So,  it's across the board. Wow. Investors are grappling  with that unknown about future rate path.

Jeff B (05:13):

Yeah,  we're a little ahead of Europe in terms of beating inflation, but you know, good news is it's on the way down in both places. So you know,  the recent weakness, I guess, you know, spreading overseas and the strong dollar you know, you're actually now seeing U.S. and developed international returns about in line year to date. So U.S. caught up maybe by falling a bit less. So you know, turning to the sectors, this is where, you know, we wanted to highlight the mega cap growth weakness, right? It's just been a really strong year for mega cap growth. That is of course mainly housed in the technology sector, but you have some in consumer discretionary and communication services as well. The big internet names, they really struggled last week, and people maybe don't necessarily think about those types of names as interest rate sensitive, but they are, right?

Jeff B (06:11):

Because a lot of the value of these growth names is in future earnings, which are worth less than in today's dollars as interest rates rise. So you see here last week, consumer discretionary got hit hard. We're seeing retail earnings this week. So maybe that'll you know, help that group stabilize a bit. But communication services, same thing. You know, hit pretty hard last week. Tech was about in line,  but certainly that's not much of a victory when the market's down almost 3%. So you know,  I think my key takeaway here, Jeff, is don't chase these strong year-to-date gains for the big growth stocks. Because we actually still think value looks a little bit better in the near-term. You know, especially if we see interest rates, you know, stay where they are or move a bit higher.

Jeff R (07:05):

Well,  in thinking about, of course, you know, the 70% of the U.S. is, you know,  what the consumer does, you know, consumer spending that's still, you know, by a long shot, you know,  the big heavy mover in the economy. So you think about, okay, what is going to start slowing down the activity, the consumer? And you know, we're going to talk about this in just a little bit, you know, the idea that you know, consumers might be rotating from such a heavy or more goods focused than they are traditionally since the pandemic and what that might mean for, you know, things like traveling, hotel spending you know, all kinds of the services side. So you know, interesting moments. Yes. And, and a good call out not to be overly quick to, you know, to focus on, you know,  what might have been big winners in just in the last past few weeks.

Jeff B (08:02):

Absolutely. So let's go to the fixed income of commodity markets. So we had rates rise, right? I mean, the 10-year yield hit, I think 393 this morning. You know, that of course translates into bond losses. So we have had some weakness in the bond market of late, in fact, across the board last week, where they look at the broad bond market measured by the Agg or the, you know, treasuries, mortgages, corporates all down. Now, the other side of that is, as rates rise bonds, you know, offer more income and, and start to look more attractive. But certainly you got to catch the top if you really want to have a big win in bonds. And, you know, we're not sure we're quite there yet as the market figures out, you know, the final destination for the yields, right? In fact, you know, right now fed funds futures markets pricing in I think 5.4% for peak fed funds you know,  the target rate for the Fed. But there are others, you know, there are folks talking about upside to that even, and our investment committee, someone cited, you know, some calls for maybe even a six handle. So not to be alarmist here, but there is risks that maybe the Fed does even a little bit more than the markets pricing in, not our base case though, right, Jeff?

Jeff R (09:29):

Right. So, you know, even the Fed knows they are still waiting for the full impact from the rate hikes from last year. So they know that it's not fully, you know, translated into, you know, the real economic activity that we see today. And so that's one of the reasons why, you know, I like to explain to our clients that, you know, even though inflation came in a little bit hotter, you know, in the last report, I think there's no necessarily change in terms of the Fed's this downshift down to 25 basis point hikes. It's going to be most interesting for July sorry, June and when we hit the summertime in those meetings, because that's when I think, you know, you get a little more clarity that the industry data, particularly industry data for rents, will filter through to the official metrics that the government supports. But yeah,  been it's been difficult for both bond and equity investors  in the last few weeks or two.

Jeff B (10:35):

Yeah. Good, good points, Jeff. Good points. So let's turn to commodities real quick and then we'll keep moving. So energy, you know, we got a little bit of a gain there in oil last week, and that was the only sector that was up. So, you know, maybe the market's finally starting to respond to the oil market, starting to respond to the China reopening, starting to respond to this better growth data in the U.S. We actually still think the energy sector is an attractive opportunity. Anything else here that you would highlight there, Jeff? Or should we keep rolling?

Jeff R (11:12):

No, I think, I think we're good. Yeah, just in terms of just even precious metals,  the choppiness there,  I think again, it's the bigger theme for long-term investors is that there will be choppiness here in the near-term across the board. But you know, that shouldn't be long-lasting choppiness, if you will. I think that's  a good takeaway.

Jeff B (11:36):

Yeah, and by the way,  our Chief Technical Strategist, Adam Turnquist, who's on this podcast periodically did a blog about copper, and actually the outlook for copper is pretty good here. So take a look at that if you're interested. LPLresearch.com. So let's keep going. S&P 500 a lot of people were focused on the test of 3,940, the 200-day moving average, you know, the stock market passed, right? The S&P 500 held that level on Friday and today. So you know, now I guess we're looking at you know, getting back above the 50-day and holding that sort of uptrend. If we drew a line from the October lows through the you know, the January lows just draw kind of a trend line we're pretty much right at that line.

Jeff B (12:29):

So we'll be watching for support, you know, kind of where we are right now for a number of reasons. We still think, you know, the stock market can go nicely higher this year, but if rates stay where they are, it's going to be tough. It's going to be tougher, I'll say. To produce a double digit gain, the Fed and inflation is, you know, based on the way we see the world now the biggest risk. So technical setup's still fairly positive, but we got some key support levels to watch. You know,  I mentioned the agenda here that you know, rate sensitivity is important to watch. So I threw this chart in, I think is a really important one for people to keep in mind the relationship between yields and valuations for the stock market pretty tight, right?

Jeff B (13:23):

So if you have higher yields, that's the upper left in this chart, you tend to have lower price to earnings ratios for the S&P 500, a way of measuring stock valuations. And then the opposite is also generally true. When you get lower interest rates, you tend to have higher stock valuations, right? So, you know, we just priced in 50 more basis points to Fed rate hikes. We just saw, you know, actually we saw the 10-year yield move by about the same amount, right? 50 basis points. And, you know, that is being felt  in the stock market through that valuation. We'll call it transmission mechanism. So if you told me right now that we would end the year at a yield of 350, which is the middle of our LPL Research forecast right now, you know, I'd say valuations are probably likely to expand and, you know, maybe the S&P 500 could even make a run at 4,500 at year-end. But if you tell me, maybe, you know, we'll be at four, four and a half I'd say, wow, we probably won't even get to 4,300 in that scenario. So while, you know, stocks have been resilient over the last couple of months against higher rates that's, you know,  it's not clear how much longer that can continue. So we need inflation to come down and we need rates to behave. Anything to add there, Jeff?

Jeff R (14:52):

Yeah, well, in some kind of a funny way to add to that is, you know, inflation coming down rates, you know, changing in essence,  you need more clarity on the consumer actually slowing down <laugh> their activities, right? I mean, you know,  go to retail space and you go to the airport and you go to pretty much you know, anywhere in this country, and you see just a lot of activity, in fact, it's interesting. Just a little bit of side note, you know,  the San Francisco Fed does a great job of breaking out supply contributions, demand contributions to the overall inflation metric. And for January, the supply contribution on inflation actually increased relative to the previous month, basically in everyday plain English <laugh>. That means that inflation is still driven in part by supply chain problems.

Jeff R (15:54):

You just can't get stuff to the consumer fast enough. So yeah, you think about, you know, yields to P/E you know, markets always pricing in, you know, six, nine months, you know, forward expectations. And so, you know, it's this idea that we're not really seeing this full impact on tighter policy, you know, higher borrowing costs, it's not really doing anything yet. Does it suggest the Fed needs to keep going? Well, yes. But we need to be careful on those lagged effects from last year's hikes to eventually slow down the economy,

Jeff B (16:35):

Watch interest rates, really, really important. So let's turn to the debt ceiling. So this is the topic of our Weekly Market Commentary for this week, Jeff, which I guess neither of us wrote <laugh>, but we have read it. Barry Gilbert and Lawrence Gillum did a great job kind of laying this out, what it means, what's likely to happen. I'll turn it over to you, Jeff, to walk through this, but, you know, no politician is going to benefit from being responsible for, you know, grandma to not get her social security check, right? Or for a government employee to not get paid, right? I mean, or the owner of a Treasury not getting their interest. It's frankly political suicide to do that. So the debt ceiling will be raised alright, it just, it will be, that doesn't mean there won't be drama though in the meantime.

Jeff R (17:36):

<Laugh>, That's a great way to say it, you know, drama in the meantime, which actually goes back to what  I was hinting at a little bit earlier in the podcast with you, Jeff, talking about, you know, the fact that this actually debate and drama now in the near term actually may set us up for, you know, a pretty encouraging Q4 perhaps, if we want to go that far out. And the reason why I say that is because, you know,  the, the government has raised the debt ceiling, you know, almost 80 times since 1960. You know,  this is fairly common. You don't always get a lot of the headline conversations because you don't always have divided Congress. So it's not an opportunity for, you know, both sides to, you know,  use this debate for all kinds of political posturing.

Jeff R (18:28):

But you know,  the ceiling is frequently raised. And  the big factor I think that investors need to think about is when is the true, you know, drop dead date when we really have a problem. It's not right now, even though we've passed the debt ceiling, Treasury can use extraordinary measures to continue to pay some of the obligations so the U.S. doesn't officially default, but the drop dead date, or the X date we call it in markets and in the sphere of investing, the X date is when, you know, Treasury runs out of funds for even the extraordinary measures that they can invoke. And so that's probably going to be around July, maybe August really depends on how the tax receipt data look, you know, so we have to wait a little bit to see how long this is going to draw out.

Jeff R (19:25):

But to your point, Jeff, I think it's really important to remember, you know, the debate, the drama will be here in the near term. The ceiling will be raised, both sides of the aisle are incentivized to actually do that. And so, you know, when you think about July, August when we finally get some, you know, clarity and get past this hurdle you know, it actually may, you know, again, set us up at that time. We'll probably see inflation numbers be a lot more favorable, you know, for markets. So, you know, inflation numbers by July, August are better, debt ceiling is passed by July. Now, of course, major unknown is what Putin does in the coming months. But some of those, you know, current headwinds that we have here may turn into tailwinds.

Jeff B (20:18):

Yeah. In a recent commentary. I refer to this as potentially a barbell year, <laugh>, right? Where we have a strong start, strong finish, and then a lot of weakness in between. And that may be the recipe when you talk about how long it's going to take for the market to start to celebrate the, you know, inflation battle having been won, right? How long will it take the market to celebrate the end of the Fed rate hiking cycle? And then you know, certainly the debt limit  can be a part of that and give investors a lot to celebrate. I mean, maybe we'll even avoid a recession, or we'll be done with a very mild and short recession by Q4, and, and we can rally in response to that too.

Jeff R (21:01):

Yep. Yep. By the way,  just to add to the story on this so we're showing here in the slide, you know, you got to go back to 2011, August of that year when, you know, we had kind of our worst scenario where there was a lot of political drama, to use your word, and Standard & Poor’s in turn downgraded the U.S. debt from, you know, from the very best to a slight, you know, slight downgrade, first time that ever happened. Markets actually started selling off before August 2011, and a little more, you know, downside after the announcement from Standard & Poor’s. But, you know,  it quickly recovered after that. Again, I think going into the summertime before that X date happens there clearly could be some downside risk if we repeat what we saw in 2011.

Jeff B (21:56):

I'll even add earnings to the equation. Decent chance we have an earnings decline in Q1 and Q2, earnings growth may resume in Q3. So there you go, setting up for maybe a late summer rally on all of these catalysts, or call it fall rally. That may be where the year is made, we'll have to see. So I guess this is our last kind of topic here, Jeff, before we go to just previewing the week. So you've made the point that the services economy has a lot of upside. So explain what you mean by that and you know, is that going to be kind of a net gain or is it just going to be a shift?

Jeff R (22:43):

Well, you see in the chart, pre-COVID, roughly 70% of your average consumer spent their money on services, 30% on goods. So that roughly 70/30, it's not perfectly, it's actually, you can see it's about 69 you know, percent on services, but roughly 70/30. COVID completely torque that. And we're still on the process of kind of reversing and kind of recovering and retooling, recalibrating. What I think is worth thinking about is a couple things. One is I think it has implications for why we see services inflation linger around so long. It's because consumers are kind of going back to, you know, that more normal ratio on spending for goods and services. So it's an inflation impact. But I think even equally important and interesting is, you know,  the shift from, you know, $450 billion could move from good spending to services spending to get us back to that long-term traditional ratio and how, you know,  the modern consumer spends their money.

Jeff R (24:00):

And so I think, you know,  there's some interesting things. Again,  the retooling is, is going to create some choppiness going back to that big picture narrative, I think, for 2023. And that is, you know, choppiness as the consumer kind of removes the goods focus and moves to services. So I think, you know, you think about, you know, what could benefit you know,  the health kind of services, communication services, who knows you know, maybe the, you know, travel some of that in the consumer discretionary categories. Now granted, you know,  you can't necessarily look at this, you know, by the typical S&P 500 sectors, but when you, when you think about the amount of money that could rotate out of goods spending into services spending is really something I think that investors need to think about going forward.

Jeff B (24:55):

Yeah,  there's no doubt that some of these post COVID transitions have really made economic data difficult to forecast, right? And so you know, maybe this is kind of the last phase and we can, we can move towards normal. So thanks for that, Jeff. We got, let's do the week ahead preview. We got durable goods this morning, which were really good, actually, if you exclude transportation, which is very lumpy. So, you know, not only did you get good orders, but you got good shipments, which goes into GDP. Any comments on the durable good? Oh, actually, before I ask that, some economists have been citing weather as responsible for some of this good January data. So takeaways from durable goods and then thoughts on the weather impact?

Jeff R (25:45):

Yeah, so, you know,  I don't put as much emphasis on the monthly orders numbers. They get revised quite a lot, but the shipments are a little more important. You know, orders can be canceled or unfilled. In fact, in this m3 report from the Census Bureau, you actually get unfilled as a line item between the orders and the shipments, et cetera. But anyway,  the point is  you highlighted the shipments component goes into the GDP calculation for CapEx capital expenditures under the business investment portion of the economy. Now, granted, it's not a large percentage, as I just said, you know, a few minutes ago the economy's, you know, over 70% consumer spending. This goes into the business side, but, you know, 1.1% gain in January, the p stands for preliminary, meaning it will be revised, 1.1% gain in January for shipments non-defense ex air.

Jeff R (26:49):

So, you know, the reason why we exclude aircraft and defense of course goes into other categories, but you got to remember that's a little bit of a payback from, you know, the previous months minus 0.6%. You got to put these things probably in kind of in three month moving average. I think it's a lot better. But I think the takeaway though is that we left 2022 in kind of a slowdown path. We were clearly slowing down. 2021 was, you know,  they're all about the reopening. 2022 was a tough year. But we are slowing down, January, it doesn't seem like we slowed down much going, heading into Q1 of 2023. So I think that's the key. In terms of the weather patterns, you know, a lot of people talk about weather patterns because when we look at data, we seasonally adjust it.

Jeff R (27:46):

And that's basically saying, you know, over the last, you know, 10 years plus, whatever that category of time you want to use, you say, okay,  we know there's seasonal patterns based on all these periods of history. Well, if the average temperature in January in the southeast is, you know, 45 but it turns out in 2023 January's temperatures were 10 degrees warmer. Well, clearly that's going to skew a little bit of that seasonal adjustment for the month. I don't spend a ton of you know, focus on that because I like to average some of this stuff out because it's so choppy anyway. Some people can use weather as kind of  a great way to explain away, you know, anything they don't like <laugh> is that they'll just say, oh, it's weather.

Jeff R (28:38):

But it, but that clearly does affect the seasonal adjustment process, given, given what I just said. I In terms of what I'm looking for this week couple things I would say, probably the most important is the March 1st data that comes out of ISM. So we know jobs are still pretty hot, we know consumer spending is pretty decent. So we're continuing to track what are businesses telling us. Because that's often the first sign of that slowdown. Businesses will start reporting a slowdown and then you'll actually see it in other areas of the economy. And, you know,  we've been seeing this for the last several months, the ISM numbers, Institute for Supply Management, anything below 50 means it's contracting. So 50 is kind of your average, right? If it's above 50, that means that the business sector's growing, below 50 as I said, contracting.

Jeff R (29:36):

So, you know, we've seen some of these numbers on prices paid falling below 50. That's clearly a good sign because  that's implying it means for us that inflation's not just decelerating, but prices are actually lower than they were the previous month. So clearly that's very encouraging for the inflation data. That's one of the reasons, Jeff, why we're a little bit outside consensus, meaning that we think at least by the summertime,  by that June meeting, the Fed's going to have some inflation data that actually looks pretty decent. We're starting to see outright price declines in the industry data including some of the data that you highlighted here with the ISM prices paid component.

Jeff B (30:26):

Yeah,  the ISM is one of my favorite economic data points because of the close relationship to earnings and has a little bit of a forward looking capability within it. So that'll be you know, important to watch. Maybe the, you know, this better durable goods number, maybe this better weather gives us a little bit of a lift. And the ISM comes in better than expected. We'll have to see. Some of you may be looking for the jobs report on Friday, well, you're off a week. It's March 10th. I don't know why that is, but <laugh>, Jeff, you probably know because I was looking for it on the third. Some sort of calendar quirk I guess.

Jeff R (31:10):

Yeah,  that's an excellent call out, Jeff, because yeah, I think most people do expect the first Friday of the month to be the job's report. It's not always the case. Part of it's driven by the fact that February is a shorter month and so you know that impacts data flow and data collection. And so that's one of the reasons why you have to wait till the next Friday. So good call out on there.

Jeff B (31:38):

Well you know, hopefully, I guess the consensus is 200,000. Hopefully we don't get something as hot as last month because we're going to just ratchet Fed expectations even higher if we do. So, you know, somewhere in that 200 to 300 range would be great if we can get it. So let's go ahead and wrap there. Thank you Jeff for joining. Thank you, all of you for listening to the latest LPL Market Signals podcast. I know Jeff, you will not be with me next week because you'll be in Europe enjoying the conference with some of our top clients. So enjoy that. Probably be, Adam Turnquist or Quincy next week. I'm not sure. We'll see. We'll just leave that as a surprise for all of you. Actually, it could be Lawrence too. We'll have to see. We got some good choices for you. So please join us next week. Thanks everybody for listening. Have a wonderful week and we'll talk to you next week. Take care everybody.

Jeff R (32:40):

Take care.