Is a Soft Landing Priced Into the Economy?

Jeff (00:00):

Hello everyone. Welcome to the latest edition of LPL Market Signals. Jeff Buchbinder here, your host this week with my friend and colleague, Lawrence Gillum. Lawrence, how are you today? How was the Super Bowl?

Lawrence (00:14):

It was, I'm great. Not as great as you are, of course. It was a very entertaining game, and  it was fun to watch. I'm sure you echo that sentiment a lot right now.

Jeff (00:26):

Yes, as a lifelong Chiefs fan, it shouldn't surprise anybody that I brought that up first. But hopefully everybody whether you're a fan or not, enjoyed the game and enjoyed the Super Bowl parties. You know, a lot of these Super Bowls are blowouts and that certainly was not, very close and entertaining game for everyone. But you know, that does mean that I am a little bit tired. So I'll try to bring good energy here with the enthusiasm that I have for my football team. But you know,  we're recording this Monday February 13th at the end of the day. And so I'm, I'll admit, I'm dragging a bit, but you'll lift me up, Lawrence, you'll lift me up. So, here's the agenda we're going to cover just as we always do, takeaways from last week.

Jeff (01:12):

Certainly Fed speak was a big part of the calendar. No doubt. So, Lawrence, given your fixed income expertise, interested in your thoughts on that. Consumer expectations rebound. That's the University of Michigan Sentiment Index, just keeps moving higher, current conditions getting better, expectations for economic conditions getting better and then the inflation expectations in that report held steady. So you know,  that wasn't enough for stocks to continue to go higher. We were down last week. I think Lawrence, I'd probably say that that first bullet point might have had something to do with why we were down.

Lawrence (01:54):

Oh, for sure. Yeah, there was eight Fed speakers last week highlighted by Jerome Powell, Fed Chief Jerome Powell. He was, you know,  they kept, kept pushing the hawkish narrative that there's more work to be done. Markets are probably starting to buy into that a little bit more than they did prior to last week. But yeah, no doubt that the Fed remains a central message in markets these days.

Jeff (02:21):

Yeah, no doubt. That, I guess the, the good news is that terminal rate going up did not cause, you know, the type of pullback we might have seen maybe last year when markets were a little bit more on edge about pricing in an extra hike. So but anyway, it certainly did impact markets. I'll show you the returns here in a minute. We did a Weekly Market Commentary this week on whether a soft landing is priced in. You know,  the thinking is as expectations improve, as more and more people think the economy is going to maybe muddle through that, you know, maybe stocks reflect that in valuations. And so we'll talk about that a little bit. I'll do a quick earnings update as we are still in earnings season. It's winding down, but still worth just giving you a quick update on the numbers.

Jeff (03:14):

And then lastly, preview the week ahead, which is of course, CPI Tuesday morning. So here are the returns for last week. You know, I mentioned the S&P down. It was down about 1%, so not terrible. We're still up about seven for the year. Got a little bit of this back, actually more than a little bit back in Monday's rally. But nonetheless, a down week last week. And I think, again, higher interest rates and the Fed, you know,  the market pricing in maybe a little bit higher interest rates from the Fed, probably the biggest reason. There wasn't really any place to hide. We had, you know, weakness in international as well as domestic, Lawrence. And then we had you know, really in terms of sectors not a whole lot worked here. But energy sure did. Anything you want to highlight here?

Lawrence (04:09):

Yeah, I mean,  it's the energy up 5% and the communication services sector down 6%. So pretty wide variation in returns for those individual sectors. So, you know, it was a volatile week if you look at sectors, but if you look at just the S&P 500, only down 1%. So positioning matters.

Jeff (04:29):

Yeah,  that communication services weakness was certainly a lot of Alphabet. And then the consumer discretionary weakness, certainly a decent chunk of that was Amazon. But generally what you saw is the defensive sectors hold up better in a weaker market, which you would expect, right? So that's utilities, that's healthcare, that's consumer staples. And the more economically sensitive areas of the market, generally, sold off more. So let's move on from that and look at your area, your specialty, Lawrence, the fixed income markets. That rate move certainly was felt for bond holders.

Lawrence (05:15):

Well, for sure. Yeah. So the Fed talking up, the more work to do narrative last week, pushed bond yields up by about 20 basis points along most maturities across the treasury yield curve. That translated into a, you know, about a one and a half percent loss for the various fixed income markets. Credit, high yield bonds were down at almost 2%. So we did see some, some spread widening there as well. So it wasn't all just the Fed narrative, but you know, we've come a long way in terms of spread tightening on the high yield fixed income market. So maybe a little bit wider spreads there, a little bit higher yields there makes sense given the uncertainty surrounding the economic environment. But all things considered, you know, a down 1% week after  as many Fed speakers as there were out there last week is you know,  it's a decent return, albeit a negative one.

Jeff (06:09):

And as you've reminded me a number of times, Lawrence, as rates move up like they did last week, that makes bonds more attractive from that point forward. So certainly we don't know where yields are going to go, but if they behave, could be a pretty good year for bonds.

Lawrence (06:26):

Yeah, that's right. So the interest rates have moved about 50 basis points. If you look at the 10-year treasury yield it has moved about 50 basis points higher since the January lows. That represents additional income that investors can take advantage of if they hadn't already taken advantage of these high quality fixed income assets at these higher yields, you know, now may be another good opportunity to add high quality fixed income assets to portfolios.

Jeff (06:50):

Excellent point. So let's flip back to stocks and look at the S&P 500 here. Really a nice looking chart. You know, we talked last week about the Golden Cross, right? Where the 50-day moving average goes back above the 200-day. So we've got that. We're right around 4,100. That's a key support level at this point. So that test maybe isn't quite over. But if we can get to the point where we've secured this 4,100 level and you know, confirmed the upside breakout there, then, you know, may, you might look at 4,300 as within reach. Now, maybe that could take a number of months but that would certainly be a reasonable price target from a technical analysis perspective. There's a couple of technical resistance points between here and there as we've heard from our Chief Technical Strategist, Adam Turnquist.

Jeff (07:47):

But we still got a little bit of room, so have an upside bias, no doubt from a technical perspective on stocks here. And our overall target for year-end based on, you know, the broad process, the fundamentals, technicals and valuations we think could, could take us to 4,400. So let's turn to this soft landing question that we want to spend the bulk of this podcast on, which is, you know, is it priced in, right? There's no doubt that the market's expectations for economic growth have improved a little bit over the last several months, and that's certainly a big reason why, you know, the stock market is up 15% off of its lows, right? So now we look at the question well is, well, first there's two questions, right? Are we going to get a soft landing? And this chart, Lawrence tells us that we got a really good chance because, you know, maybe you have to take out that anomaly. The last jobs report was just ridiculously strong, kind of out of nowhere. And we don't think that's going to be repeated. But if you look at the moving average of this number, this is just monthly payrolls, it's been gradually moving lower. That's what you'd want in the soft landing.

Lawrence (09:02):

That's absolutely right. Yeah. The Fed wants to reduce or soften the strong job market to reduce aggregate demand to help offset some of those inflationary pressures. And they want to do it gradually, right? They don't want to in increase the unemployment rate too dramatically where they're throwing, you know, millions of people  out of work, out of jobs. So this gradual decrease in job gains over the course of the past 12 months or so, has been a pretty good narrative in terms of you know, reinforcing that soft landing you know, possibilities. January, we've talked about it maybe some of that additional job growth was seasonal factors that were, that were changed recently. But the direction that trend is certainly moving in the right way to suggest a soft landing is still probable at this point.

Jeff (09:54):

Yeah, I mean, maybe  we'll be vague and say it's, you know, close to a coin flip, but no doubt it's a real possibility. Whereas just a few months ago, you know, most people would say very low probability that we actually avoided technical recession. So the job market's good reason why we might get a soft landing. Here's another reason, again, this is from the Weekly Market Commentary this week that you can find on lpl.com. And this is one of my favorite charts to, you know, help explain how consumers are actually in pretty good shape, right? I mean, a low unemployment rate does it <laugh>, right? Where basically 50 year lows of unemployment. But you know, there's so much focus on the debt. So this just takes the debt obligations relative to income. That's the financial obligations ratio. And you see here that consumers can afford to pay the debt that they have right now, right? Even though rates have gone up. So I look at this as saying the consumers still have plenty of fire power to, you know, at least get through the year. So, you know, I think if you're going to make the case for a soft landing and we are, generally, this has to be part of the story.

Lawrence (11:13):

Yeah. And the point I would make is a lot of this debt is fixed straight debt too. So despite the fact that interest rates have moved higher we're not seeing these debt payments reset higher as well. So the, you know, the consumers in pretty good shape from a balance sheet perspective. And that's one of the things that we're really missing from say, you know, this rate hiking campaign versus past, you know, Fed rate hiking campaigns is there's just not a lot of over levered consumers or businesses. Leverage has been really taken out of the system. So you know that's making a difference in terms of the stability and the sustainability of consumer spending.

Jeff (11:52):

Yeah, you could say that maybe the upside of going through the financial crisis was that, you know, consumers and businesses cleaned up balance sheets. And so that means your business cycles probably aren't going to be as dramatic going forward. And certainly this one's lining up to be you know, a very short and shallow recession, if we do get one. So this is a positive story. So again, we're not saying that a soft landing is likely, we're saying, you know, maybe it's more likely than a coin flip. But certainly, you know, with consumer spending being such a big part of the economy, 70% or so, if consumers are in good shape and continue to spend, then you know,  those chances increase with consumer sentiment improving you know, well else and the debt manageable and unemployment low consumers are going to continue to spend.

Jeff (12:43):

They also have a lot of excess cash still sloshing around. So things are looking up, things are looking up, no doubt. Now this is where the conversation gets a little trickier, Lawrence, because, you know, we ask questions that priced in, maybe you can weigh in on the bond market and how much of a soft landing's priced in there. But in terms of the stock market, a good chunk of a soft landing is probably priced in, but we don't think all of it. So this chart just shows stocks relative to bonds on an earnings yield basis, okay, called the equity risk premium. So what kind of earnings are you getting out of the stock market compared to what kind of earnings, which are really called yield. What kind of earnings are you getting out of the bond market and how does that ratio look?

Jeff (13:31):

So if you're above this, you know, orange dotted line you know, that means stock valuations look better than bond valuations. So that's a positive equity risk premium relative to long-term average. So despite the fact that stocks have gotten a lot more expensive you know, as yields have risen, that still, you know, I mean the end result here is still fair valuations or maybe even a little bit cheaper than fair. This might surprise some people, but based on this measure, and we think that yield should be a part of the valuation discussion, kind of brings, you know, my specialty and Lawrence's specialty together. We would say stocks look, you know, pretty fairly valued here, or maybe even a little bit cheap. What do you think, Lawrence?

Lawrence (14:17):

Yeah, I think that's fair. I mean,  we've seen a big move higher in prices over the past, say several months, but you know, yields have fallen during that time period as well, most recently since the December highs and treasury yields. So, you know, all in all you come up with fair valuations for maybe stocks and bonds.

Jeff (14:37):

Yeah, I think that's right. So, you know, asset allocation decisions or stocks versus bonds in most cases. You can use alternative investments too, but you know, they can both look good. And that's kind of where we are right now, right? We think maybe yields could move a little bit lower. And we also think, you know, after this little soft patch in earnings, earnings can go higher and stock valuations, you know, aren't that expensive. If you just take a simple P/E forget about interest rates, just simple P/E, it's in line with the long-term average. Or at least if you go back, you know, a few decades, not if you go back further than that. You know, in the old days, stocks were just cheaper for a number of reasons. But just the last few decades, you know, kind of a trailing P/E of 19, last four quarters earnings,  that's pretty normal

Jeff (15:32):

these days. We've certainly been higher than that. So we would argue valuations are fair, and that means some odds of a soft landing are reflected in prices, but they're not fully priced in. Also consider that earnings are a little bit depressed right now because of inflation, right? This is why companies are cutting costs to try to support profit margins. After we get through whatever you want to call this period, it's kind of a stagflationary period. After we get through it, earnings are going to have some upside, and we think that can lift stocks. Now we're maybe talking 2024 not 2023, but certainly there's some upside to earnings. So that kind of completes the question of whether a soft landing is priced in. I'll also point out though, that, you know, higher risk stocks versus lower risk stocks, that looks a little bit stretched.

Jeff (16:23):

So this actually kind of points in the other direction. If you look at how well higher risk stocks or more volatile stocks have done, rather than, you know, versus the lower volatility stocks, just year to date, it's one of the biggest runs of out-performance we've seen in decades. Okay? So that tells you the market is pricing in a soft landing, right? Because the market is embracing risk by favoring those higher risk stocks. So there's risk here, this is not clear cut. Wanted to kind of point that out in the  interest of being balanced. So let's turn to earnings. Well actually, unless Lawrence, you want to weigh in on the soft landing odds being priced into the bond market?

Lawrence (17:05):

Well, yeah, I was going to make two comments. It depends certainly on which market you're looking at. You know, as we know following markets, there's no real black and white kind of narrative there. So it's, if you look at just the high yield market, it's similar to the high beta names that you just mentioned. High yield markets are really pricing in you know, whether it's a soft landing or even a no landing, you know, <laugh> the high yield market is pretty optimistic about economic growth on a go forward basis. But if you look at the rates market, and if you look at the yield curve inversion, meaning these longer maturity treasury yields are lower than shorter maturity treasury yields, which is the opposite of what happens in general. And that tends to happen around a time where economic growth may be slowing and recession risks have increased. We're at the deepest levels that we've seen for that yield curve inversion since the eighties. So, mixed messages coming out of the fixed income markets. Who's right, you know, we'll see. We think maybe that you know, we're leaning kind of indecisive at this point, frankly, just given the mixed data that we're getting out of the economy. But we are getting some divergent signals coming out of the fixed income markets as well.

Jeff (18:18):

Yeah, this is why you've heard some, you know, money managers that have a lot more experience than I do saying this is one of the most difficult environments that they've ever seen, right? You don't really have a playbook for this, which is why maybe it makes sense that we would just say it's a coin flip and we're just going to have to wait for more information. It's not a high conviction type of call. So thanks for that. Let's shift to earnings, Lawrence, and talk about you know, latest numbers. We we're tracking about a 5% decline, which is a miss. We very rarely get misses. I guess there's a tiny bit of good news here. That number is a little better than it was last week, and you've still got, you know, 70% beat rate, which is not terrible.

Jeff (19:06):

You've still got 4.7% revenue growth, which of course is good, helped by inflation, but still good. And forward estimates for the S&P 500 have not quite fallen as much as people thought. So you've seen the market react positively to what appears on the surface to be pretty weak earnings suggesting that, you know, expectations maybe just got too low. When earnings season began, I don't know if I made this prediction on the podcast or not, but I certainly made it on internal calls. I predicted we'd see earnings fall maybe between $5 and $7 for S&P 500 this year. And that's exactly what's happened. Now, we're not done yet, but that tells me that, and I may be more of an earnings bull than most, we're about 80% done with the market cap in earnings season, it's not going to move that much. So what that tells me, the market's positive reaction to a cut of $7 off of earnings per share. We started at 230, roughly, now we're around 223, 224, right? I think, I mean, the market probably expects more downside here, Lawrence, and that sets up a potential upside surprise where bad news is actually well received. What do you think?

Lawrence (20:30):

Yeah, I think that's one of the more intriguing things about this earnings season is that I think you pointed it out earlier that some of the bigger misses have produced the biggest upside surprises in terms of performance just because the narrative has been so negative lately. And you showed a chart earlier in this podcast about the rally from the S&P 500. I mean, think about the rally that we've had since October. It's, you know, despite all the negative news out there and all the geopolitical issues and the balloons and all this other stuff, it's just amazing how resilient this equity market has been and continues to be. Just because I think there's a lot of negative sentiment out there that's starting to reverse a little bit, which is good to see.

Jeff (21:14):

Well, you know, those balloons were sent by aliens, right, Lawrence? So they're friendly aliens, right?

Lawrence (21:22):

I mean,  it's 2023. It wouldn't  surprise me at this point.

Jeff (21:27):

Anything can happen. Oh, but just, just a crazy, crazy story. We'll be interested to hear kind of what the government figures out when they, you know, I guess they haven't found all these yet, so stay tuned, but man, what a crazy story that is. So yeah, I think that the, to put a bow on the earnings discussion, news has not been great, there's no doubt. But the market actually seemed to have expected worse and in the end has responded positively. So we'll probably do you know, one more quick earnings update maybe in the next week or two, and that'll be the end. It's pretty much over for earnings season. And frankly, just getting through it is probably the best news because it was hard to see it being an upside catalyst. We have seen some cost cuts be well received, right?

Jeff (22:22):

I mean, certainly the Meta results, formally Facebook, you know, certainly making better use of capital or cutting costs and being more efficient, that sort of, that sort of story. That's just an example. That sort of story has been pretty well received. I think you saw the same thing from Disney and others. The market's concerned about margins and overspending, right? Which certainly a lot of tech companies did during the pandemic. And the adjustment coming off of that I think has gone a little bit better than maybe a lot of people thought. It'll continue, but it's certainly you know, we've certainly seen a lot of progress  in that regard. So let's turn to previewing the week, Lawrence. Most of this is kind of continuing the same discussions we just had, right? We have CPI tomorrow morning, so by the time you hear this, you will have seen the CPI. I think inflation and, well, there's more Fed speak too, but I think inflation with CPI and PPI is the most important data of the week.

Lawrence (23:24):

Yeah, for sure. Retail sales will be looked at as an important measure of the consumer. But it, yeah, it's all about inflation and really the real average hourly earnings will be interesting to see as well, to see if there's any sort of these wage price spirals that are maybe concerning to some Fed officials. We don't see that happening in some of the other data, but, you know, markets will certainly be paying attention to that data release as well. But you know, frankly, it's all about the,  CPI. There are 11 Fed speakers this week though, too, so, wow, that should be fun to listen to all of those Fed speakers this week.

Jeff (24:04):

I think I'll just continue to celebrate the Chief's Super Bowl victory, rather than listening to all those Fed speakers, maybe look for some souvenir t-shirts or something. I'll let you handle that, Lawrence and Jeffrey Roach and Quincy Krosby and the rest of the team. I love listening to Powell and I'll always listen to everything Powell says publicly. But I'll leave the rest of the Fed speak to you. So thank you for covering that. I actually think that retail sales might have a little bit of downside risk. You know, those expectations are not layups. We'll see, hope I'm wrong, but you know, it's, I mean, we just talked about how the consumers, you know, balance sheets are still quite strong, and that's true, and the job data is excellent, maybe too good.

Jeff (24:52):

But, you know, coming from December to January, I don't know. We'll, we'll see, we'll see if consumers start off the year spending strong. And then the last thing I think you highlighted here, Lawrence, is the leading economic index. So you know, that's another signal that's telling us we're going to have a recession, probably a mild one, but that's certainly telling us along with the yield curve and other indicators. Certainly we have our you know, our antenna up to, you know, make sure we know if we're wrong. We come to that realization as quickly as we can and adjust accordingly. Still, you know, we'll call it 50-50 on soft landing, maybe a little bit better, but man, some of these indicators are clearly pointing to recession, which goes back to this cycle just being so unique.

Jeff (25:45):

And there is no playbook. The 1970s aren't a great playbook either, but that's certainly where people typically go, you know, or early 80s to try to find an environment that looks like this one. I'm not sure how helpful that is  to be honest. So certainly we you know, we'll continue to watch the data and, and go where it tells us. But man, you know, this would be quite a soft landing and I think would surprise some folks, if we can muddle through, while some of the most effective recession indicators  are still clearly pointing to recession. So you want to send us home with any final comments on this? Lawrence?

Lawrence (26:26):

No, it's going to be a busy week of Fed speak as you pointed out. I’m going to be listening to everything that they all, they all say. So I'll be busy this week, and, you know, along with that I'll be watching some paint dry and some grass grow because those are exciting for me, apparently, while you go out and celebrate your Chiefs.

Jeff (26:45):

Yes,  I wish I could attend the parade, but no such luck, not going to make it to Kansas City on Wednesday. I'll live through my family's joy that the family that I have that's still there. So with that well, by the way, Eagles played an amazing game. Jalen Hurts was really, really impressive. So hats off to the Eagles. Wow. Hurts was more than good enough to win a Super Bowl. So with that, let's go ahead and end it. Thank you Lawrence for you know, being the fixed income for my equities. I didn't want to get too optimistic, too ebullient after the football game yesterday. So you kind of helped keep me level. I'll actually be on vacation next week, so we're going to have we'll call it a mystery host. I won't spoil who the host is going to be, but you will not hear from me. My guess is you won't hear from Lawrence, although maybe, I don't know, Lawrence, have you had discussions with this mystery host about jumping on next week?

Lawrence (27:48):

I have not, but I'm intrigued to learn who it is now.

Jeff (27:52):

All right, well, everybody will just have to join us next week to find out. So whatever it is, it'll be, or whoever it is, they're going to do a great job. So please join us next week for another edition of LPL Market Signals. Thank you everybody for listening today. Thanks again, Lawrence. And we will talk to you next week.