Perspective on Profits and Pauses in the Fed’s Rate Hiking Campaign

Jeff B (00:00):

Hello everyone, and welcome to the latest LPL Market Signals. Jeff Buchbinder, your host with my friend and colleague, Lawrence Gillum. Lawrence, thanks for joining this week. How are you?

Lawrence (00:12):

I'm doing great, Jeff. Thanks for having me again, it's the day after Mother's Day, hopefully all the mothers had a great day yesterday and you know, we spent yesterday with my wife, who is a mother of our two kids, and it was a great weekend, but we're ready to get back at it this week. It's a busy week for fixed income investors, which we'll talk about. But great to be here, Jeff.

Jeff B (00:35):

Awesome. Well, I bet as you were celebrating Mother's Day, you were thinking, I can't wait for the 14 Fed speakers this week. That's what I was thinking.

Lawrence (00:45):

Yeah, we'll talk about that in a second. But yeah, it's a lot this week. But hopefully we won't see this again next week, because there's just a lot of Fed speakers out there this week.

Jeff B (00:59):

No doubt. No doubt. And not my favorite thing, but I'm an equity guy, so you get it. No offense meant there. So yeah, so hi to all the moms. Hope you had a great Mother's Day and certainly we appreciate you much more than just one day out of 365, moms. So hopefully you guys get all the kudos you deserve every day. So, here's our agenda for today, it's going to be a fun call because we've got some really interesting topics here. First you know, we'll recap the week as we always do. Got some inflation data and we'll still continue to follow the debt ceiling news, better than feared undersells earning season. I mean, this has really been an excellent earnings season relative to expectations as we've talked about here the last couple of weeks.

Jeff B (01:52):

But I've got some numbers that I think are going to really put it into perspective and, and maybe surprise some of you because so many folks have been calling for earnings to weaken dramatically. Next, and this is where Lawrence comes in. We're going to talk about the Fed pause, which appears like it's locked in, but there's certainly a chance that we get a June hike. And then lastly we'll talk about the week ahead retail sales and of course, the debt ceiling are the big events of the week. Not a whole lot in terms of earnings reports coming except for some big retailers. So, jumping right in. So, S&P 500 chart here, range-bound is the word. I think it fits this chart really well because essentially for the last couple of months we've bounced around but really haven't gone anywhere.

Jeff B (02:47):

And this you know, the February highs at around 4,180 have been very tough to break through. Debt ceiling might not be enough to get us through that level. We'll have to see, could take some time, but, but this is kind of a range-bound market. A lot of attention on breadth recently. So not only do we have kind of a sideways chop to the market here, we also have dipped below the 50-50 line in terms of percentage of stocks that are above their 200-day moving averages. So you know, we'll see where we go, but it's been kind of a quiet you know, quiet, let's say six weeks. I think this is six straight weeks where we've not moved more than 1% on the S&P 500. We have just dipped a little bit, as you can see here, down 0.2% last week.

Jeff B (03:41):

You know, the inflation data was fine. We got a four handle on the CPI, which was good. But there's still anxiety around the debt ceiling as well as on the bank failures or potential that we'll get more bank stress. The NASDAQ was a notable outperformer. We had some big tech winners. You see that on the sector table to the right. Technology wasn't necessarily a good performer last week, but discretionary was with Amazon and comm services was with Meta and Alphabet. How about on the bond side, Lawrence? Thoughts on the the fixed income performance last week, which you see here?

Lawrence (04:26):

Yeah, I mean, just to echo what you said about the equity markets, rates have been range bound as well. We've not seen a big move, frankly, in either direction. As it relates to 10-year treasury yields, they're bouncing around 3.5%. So, for the week it's been kind of just, you know, slightly negative to slightly positive depending on where you look. I think we're going to be in this range for a little bit longer until markets figure out what the Fed's going to do, until the Fed figures out what the Fed's going to do potentially. So, we could be in this range-bound period for a little bit longer and, you know, we're looking at, you know, coupon type returns over the next few months. But you know, after the negative year that we saw last year, we'll take these slightly positive or even just slightly negative returns on occasion for sure.

Jeff B (05:13):

Oh, no doubt. Much better for equity investors and fixed income investors this year than last. So, you know, not a bad story there at all. I mean, energy continues to struggle. Let's turn to inflation. The you know, this is a heat map by our chief economist, Jeffrey Roach. By the way, I should have mentioned this before, but it's May 15th as we're recording this. The you know, the heat map is really green, right? It moves through time left to right and pretty much every measure of inflation has gotten better. This rent CPU item is the one that sticks out that really hasn't started to improve. But Lawrence, you know better than I do. The real-time measures of rents have already signaled that this is going to get better, right? So, you can, you know, we have a much better supply chain picture now. We've seen that in the data. We have evidence that the rental inflation is coming down, right? I mean, certainly we've seen it in commercial real estate here recently. The Boston office for LPL just moved <laugh> to a new building. We've lived that one. So, this looks pretty good. Maybe, you know, play devil's advocate. Does it look as good as I think it looks or what should I be watching out for?

Lawrence (06:39):

No, it definitely looks good and certainly much better than this time last year. So there's been a lot of good progress made on the inflationary front. If I were to nitpick, and this is just me being a bond guy that always sees the world half empty. It's that bottom line. The PCE core services, ex housing still above 4%, which is the, you know, that's the metric that the Fed talks about or Chair Powell talks about. That one hasn't been moderating as quickly as everything else on that heat map. But by and large, I mean the inflationary story probably isn't going to be an inflationary story this time next year, right? So we are making some pretty good progress here.

Jeff B (07:20):

Yeah, we think we'll have a three handle in the fall and then it should get better from there. Not a straight line down maybe, but certainly the outlook is good. And if it's not, we can blame Dr. Roach. So let's move forward. He's not here to defend himself. So, Fed pause I guess we switched the order of these because, you know, the fixed income guys always go last, right? So even though I, you know, put the earnings first in the agenda, we'll talk Fed first. There's been a lot of attention on what the Fed means for stocks, right? But maybe not as much for bonds. So, Lawrence, you put a couple charts together that show the path of rates after a pause. And it's actually quite interesting.

Lawrence (08:06):

Yeah, it's good news for fixed income investors. Again, the big question mark is, is the Fed going to pause? Right? We've talked about this a lot in our Strategic and Tactical Asset Allocation Committee meetings. Is the Fed done raising rates after last week's inflationary data? You know, perhaps they are, it's not a clear, you know, slam dunk just yet, but maybe the Fed is going to pause at its June rate or June meeting and maybe keep rates elevated for the next couple months. But you know, that's good news or it has been good news for fixed income investors. So what we're showing here is the direction of 10-year Treasury yields after the Fed has stopped raising rates. So on average, 10-year Treasury yield is down or is lower by about a percent over the course of the next 12 months to over the next year, we tend to see rates fall by about a percent.

Lawrence (08:59):

You know, certainly that does vary based upon the year, the individual year which are those squiggly lines. Those are the years, I should have identified that earlier. But you know, for example, in 1995, we saw about a two and a half percent decline in 10-year Treasury yields after the Fed stopped raising rates. For 2006, not as big of a fall in treasury yields, down about 75 basis points, but then reverse some of that falling yields. But by and large, we do tend to see a fall in Treasury yields after the Fed has stopped raising rates. And again, that's good news for fixed income investors. The Fed pushed interest rates higher last year, which caused bond prices to come down pretty significantly. It makes sense that as the Fed stops raising rates, bond prices will go up, bond yields will go down. So that's kind of our expectation over the next 12 months. We do think yields are going to be lower than where they are currently. It's just, we're talking about magnitude of how much lower they're going to be. But we do think that there is a bias towards lower yields over the next 12 months, which again, should be good for fixed income investors.

Jeff B (10:08):

Yeah, this is maybe a little more, you know, negative for yields than I would've guessed before I looked at this data because you know, typically a Fed pause is late in the cycle. You know, you're coming off of accelerating growth, which typically comes with rising inflation. And you know, I mean, I would've made the case that maybe yields could go higher, but and maybe they did for just a bit in maybe the 1989 cycle, but it was really short-lived. And yields go down. So, this is good news for bond investors, as you alluded to, Lawrence, even as an equity guy, I see that, and that, you know, creates a higher hurdle for equities to clear, to outperform fixed income if this scenario plays out. So, you know, this is why we're having active discussions about, you know, whether we want to trim equities or not in our tactical asset allocation committees. So, you did another chart, Lawrence, it's similar concept, but a different story, which is what happens to spreads after the Fed pauses.

Lawrence (11:14):

Right? It's not as clear as it is with treasury yields. Corporate spreads were mixed. So, that additional compensation for owning riskier debt and what we're looking at here are BBB rated corporates. So, this is, you know, a big universe of the investment grade corporate credit market. They're within the rating scales. BBB is the lowest rated cohort of that investment grade rated universe. And after the Fed stops raising rates after the Fed, you know, gets to its terminal rate and pauses, spreads have been mixed. Spreads have been wider certainly pre-2000. When we look at the most recent periods, 2006, 2018, we did see spreads about flattish or even lower you know, the spread widening back in 1989, 1995, and 2000. We know certainly that's bad news for fixed income investors.

Lawrence (12:10):

We want tighter spreads all else equal. But we did see wider spreads in those three you know, rate hiking campaigns. Of most recent time, time periods though we did see you know, tighter spreads, which again, are good for fixed income investors. If I had to guess, given where levels are currently, I would tend to think that we would start to see maybe flattish to slightly tighter yields within the corporate credit market, given the quality of the universe, the high-grade corporate credit universe has upgraded balance sheets. And you're going to talk about earnings here in just a second. And, you know, the surprisingly positive earnings picture has certainly followed through into the corporate credit markets. So again, not a clear picture, not as clear a picture as we see on the rate side but maybe not as negative as maybe some people think on the credit side as well.

Jeff B (13:07):

Yeah, so I mean, this is really interesting too. You know, maybe you get a little bit of a benefit from rates, but you possibly give a little bit back in terms of credit widening, because typically after the Fed pauses, you know, you do start a recession within the next, I mean, it varies, but within the next year or two. And that's when you start to get a little bit of spread widening. So, we think we have a window here certainly before recession where, you know, hopefully you can get spreads behaving and get a little bit of a kicker from lower rates. So you know, maybe stocks can make up a little ground here near term and bonds too. Oh go ahead.

Lawrence (13:49):

A big takeaway it, I guess when you put those two together you know, if you look at the aggregate core bond index, the Bloomberg Aggregate Index, which is that core bond index, on average overtime after the Fed stops hiking rates, six-month performance has been around 8%. One year performance has been about 10%, I'm sorry, 13%. And then three year performance has been about 10% positive returns. So, we could potentially start to claw back some of those negative returns that we saw last year, just because the Fed is not raising rates at the aggressive clip that they were last year. So again, you know, we did see spread widening in a couple of these situations, but all told all in, you know, we do expect a more positive picture for core fixed income now that the Fed, we think, is potentially done with raising rates.

Jeff B (14:44):

And you'll have some of this in the Midyear Outlook publication that we are starting to draft, now. That's still a ways off, I think probably about what, seven weeks away from publishing, but we're starting to put some words on paper. So really looking forward to getting through that. So earnings recap. This is the subject of the Weekly Market Commentary. Lawrence, you alluded to it a little bit. You know, corporate America's in good shape and that helps the spread outlook, certainly. And by the way, if rates come down a little bit, it actually helps ease the bank stress a bit. Because remember the, you know, the biggest problem with the banks has been rate risk, not credit risk. So you know, there's a side benefit as well. So, let's go through a few charts on earnings.

Jeff B (15:37):

And this is a really positive story relative to expectations. But we did adjust our earnings forecast down a bit today. You can get the Weekly Market Commentary on lpl.com. I'll say this is probably the most positive estimate cut I've ever done. And I've been cutting estimates for 25, 30 years, <laugh> in this business. I can't remember one, whether it's individual companies or the broad market. You know, my former life, I cannot remember a more positive estimate cut in my entire career, <laugh>. So with that as a setup so here's the trajectory of earnings. You know, we had the nearly 6% earnings decline in Q4 and now we've narrowed that to down about 2% in Q1. Coming into Q1 reporting season, we were looking for down seven. And frankly, based on last quarter, you know, Q4, a miss would not have surprised us.

Jeff B (16:38):

You know, something in the neighborhood of, you know, down seven, down eight. Down two we did not see coming. And it actually could get a little bit better than that because we still have some S&P 500 companies left to report. So that's a good story. Now we're not going to trough until Q2. It appears likely that will be the trough. Consensus is still reflecting, you know, down six. But nonetheless, great to, you know, more than half that decline from Q4 to Q1. Here's another positive story. And this kind of feeds into your world, Lawrence. It just shows you that, you know, companies are in good shape. We've actually seen margins inch higher quarter over quarter. I don't think anybody saw this coming. So that's the first piece of good news, right? But the other reason I really think this chart is interesting is because if you look back at previous mild recessions, which is what we think we're going to get, margins contracted on average by a little bit less than 200 basis points, okay?

Jeff B (17:44):

So, we've already done that. From the peak in 2021, to Q4 margins contracted by about 200 basis points. So, you could make an argument that we're done with margin contraction based on prospects for a mild recession. That might be a little aggressive. But it's certainly a reasonable argument. And I would say most likely any additional margin contraction we get, even if we get a mild recession, is likely to be limited. Now if we get a typical recession or something worse than a typical recession, that's a different story. You know, you could see another a hundred or 200 basis points of contraction beyond that. So, but nonetheless, I think base case is most, if not all of the margin contraction is behind us. Another piece of good news and then I'll bring you in Lawrence for any comments you have on this.

Jeff B (18:40):

The 2023 estimates, which frankly everybody thought or still thinks <laugh> are too high and we're included in that, we think they're too high too, they actually went up. So, the cut to estimates for Q2 through Q4 did not fully offset the upside in Q1. So, you end up with higher consensus estimates for 2023 for the S&P 500 it's 221 similar to the margins situation. I don't think anybody expected this either, or very few people expected this very resilient performance from corporate America. So, here's what we're doing with our estimates. I's an uncertain economic environment. We'll all admit that. So, we did this probability analysis where we looked at, you know, three different scenarios for earnings, kind of a bull case base case and bear case. And if you probability weight these, again, we think there's a much higher likelihood of either a muddle through or a mild short recession than a typical recession.

Jeff B (19:50):

But if you know, kind of probability weight, these, and you know, Dr. Roach actually kind of pushed back a little bit on this 55% chance of mild short recession. It's probably two thirds or maybe even a little bit higher. It really doesn't matter when you probability weight this, you get into this 212, 214 range you know, with reasonable assumptions, we think so, you know, that's about eight, nine dollars of downside. And that may sound like a bearish development, but analysts expect generally or strategists expect lower. And any top-down, you know, pundit you talk to expects lower. In fact, the consensus of top-down strategists is about 210 right now. So we actually would be, we think the market reaction to a higher number than 213 would be positive. What do you think, Lawrence?

Lawrence (20:46):

Oh yeah, for sure. I think the last couple recessions have really weighed on corporate, you know, treasurers and CFOs and I think they've done a fairly good job of fortifying balance sheets. And, you know, we saw the fixed income markets, these corporate borrowers, they termed out debt, which means they issued a lot of debt at lower rates in longer maturity so that, you know, they have a lot of financial flexibility on their balance sheets still. So corporate America is still in pretty good shape and you know, I'm usually known as the pessimistic guy, but the fact that earnings have surprised to the upside, maybe that's not overly surprising. You know, because we've talked about this, corporate America is still in pretty good shape and there's still a lot of demand out there for goods and services. It's falling of course, but corporate America is a good spot, I think because of you know, these strong balance sheets they have currently.

Jeff B (21:47):

Oh, no doubt. So, inflation is falling and is likely to continue to fall. We think we're going to get a little bit of weaker dollar, which helps prop up international earnings for U.S. multinationals. So that's positive. And then in an inflationary environment, you get more revenue. Seems like, you know, some of the shops out there forecasting earnings have missed that a bit, right? So, we had consensus was like 2% revenue growth and we, it looks like we're going to get over four. And that, you know, that incremental revenue of course helps margins and helps the bottom line. So, you know, in fact, you could even argue, I mean, we're not saying 220 is impossible for 2023 S&P 500 profits. You could make an argument that that's a reasonable number. It's kind of flat year over year because of how earnings held up a little bit better in inflationary environments historically than in maybe a traditional recession with low inflation and or risk of deflation, which is worse for corporate profits.

Jeff B (22:58):

So keep that in mind. I mean, there are some shops out there that are still in the 220 range, but it, you know, Goldman Sachs is one, but it's hard to find <laugh> people that think 220 is possible. So, check out our Weekly Market Commentary on lpl.com walking you through first quarter earnings season, which is pretty much over. So let's do the week ahead, because we still have retail, right? Which reports late, earnings season is not over. Consumer discretionary has actually been one of the pleasant surprises this earnings season. We've had that sector generate the biggest upside surprises, frankly. So maybe we'll get some more good news from the retailers that report this week, including Walmart and Target. But other than that, we get some economic data that I think is going to be interesting.

Jeff B (23:51):

Retail sales. Now remember these are nominal numbers, so they're not adjusted for inflation. So that 0.8 you know, it's not as strong as it looks because when you take you know, whatever it is, 30, 40 basis points away for price changes, you end up with a more modest number. But nonetheless, this is a positive number. And the data so far, there hasn't been a lot of it, but the data so far, for Q2 has been pretty good. So probably get a decent number for retail sales. Anything else here you would highlight Lawrence? Either the data that I've highlighted or any data that's not.

Lawrence (24:34):

Yeah, it's a light, a relatively light week for economic data as you pointed out. Retail sales will get a lot of the attention leading, index leading economic indicators will get a lot of attention as well, but I mean, your headline here about the the debt talks is important. I think President Biden and House Speaker McCarthy are meeting scheduled to meet tomorrow, I believe, to talk through some of this. So hopefully there's some progress there on the debt ceiling. But as we kind of alluded to at the beginning, 14 Fed speakers this week, including Chair Powell on Friday speaking on a panel with the ex-Chair Ben Bernanke. So that'll be riveting as usual. But you know, it'll be interesting to see if there is a coordinated message coming out of the Fed about these higher rates for longer or if there's going to be a disparate kind of message out there. We are already starting to see a couple of disagreements in public from some of these Fed officials. But I'm of the opinion that maybe less is more in some of these situations that we don't need 14 Fed speakers out there this week. But it is what it is.

Jeff B (25:43):

I don't think I've ever agreed with you more Lawrence <laugh> than with that. I mean, the Fed headlines are interesting and the Fed, you know, I'll be the first to admit that it's a really important factor in, you know, not just fixed income markets, but equity markets as well. But there's no way anybody can make sense of 14 different speakers and <laugh> try to, you know, come up with one you know, harmonized view of the world. There's just too many disparate views. Hopefully they'll all be coordinated and they will give similar messages, but you know, it can be dizzying <laugh>. So, but I think what's probably most interesting is that there is a little bit of a probability of a June hike. And so people will maybe move that low number around a little bit, right?

Jeff B (26:32):

And you know, we'll see where that stands at the end of the week. I guess the you know, besides the debt ceiling and earnings, retail sales, probably the claims number will get some attention, right, because it's elevated. I mean, historically, now our base case is recession. And historically when you get, you know, moves and claims of 60, 70,000 or more, you get a recession, it's pretty much a hundred percent batting average. So we are likely to get a recession. It's just a question of how mild it will be. And there's a little bit of doubt in that because of how low claims were at the start of that increase. So, you know, nothing's a hundred percent, but high likelihood of a recession based on claims. So that'll get some attention. And then the leading economic index, which like your yield curve, Lawrence, seems to be a favorite of folks arguing for a recession and further declines in the market. I mean, that data's already known, essentially, you're just kind of aggregating known data and creating an index out of it. So it's not like we're going to be surprised by that reading, but it is signaling a recession, probably Q4 in our view, but it could leak into Q1. So anything else to highlight here, Lawrence, before we bring it to a close? I don't, about more about the Fed speakers?

Lawrence (28:00):

No, we've talked enough about Fed speakers. We don't want to add to that that noise there. So, no, I think we've covered a lot. Should be a good week. Hope everyone has a great week out there. And yeah, should be a busy one though.

Jeff B (28:15):

Yeah, absolutely. Frankly not any real inflation data this week but plenty of else other things going on to keep us interested. So with that we'll go ahead and end for this week. Thanks Lawrence, for joining. Thanks all of you for joining us tuning into another LPL Market Signals. We will be back with you next week. Take care everybody.