Reaction to the Fed’s Jackson Hole Jolt

Podcast Intro:

From LPL Financial, welcome to Market Signals.

Jeff Buchbinder:

Hello everyone, and welcome to the latest edition of LPL Market Signals. Jeff Buchbinder here, Chief Equity Strategist, LPL Financial, with my friend and colleague, Jeffrey Roach, Chief Economist, LPL Financial. How are you today, Dr. Roach?

Dr. Jeffrey Roach:

Hey, doing great. And I'm glad to say that I'm calling in today from the Fort Mill office, so I crossed state lines here, came down from North Carolina to South Carolina.

I'm always surprised when I hear how much traffic there is down there, but glad you made it. Glad you had time to bring the heart rate down to get ready to bring it back up again with an exciting markets discussion.

Hey, I have driven a nine passenger Peugeot van in Moscow, Russia. So, I can handle the the trip down to South Carolina.

Jeff Buchbinder:

Wow, very impressive.

I would probably not recommend doing that right now, but good background to have nonetheless. So, let's get into it. We are titling today's podcast, "Jackson Hole Jolt". Certainly, the markets got jolted on Friday. Some of that selling pressure carried over into Monday. So, we'll talk about that first. And related to that, is the Fed getting whipsawed again? They were late to tighten ahead of the inflation surge. Mischaracterizing it as transitory. Now they could be wrong again by getting too tight or staying too tight, too long, and driving the economy into recession. So we'll talk a little bit about that. The third point, corporate America, just going to do a really quick recap of earnings season because it's in the books and it was pretty good all things considered. Then lastly, is energy a buy? The energy sector has been picking up here recently, and we think looks like an interesting opportunity.

So, let's start with the Jackson Hole jolt. Jeffrey, you're one of our primary Fed watchers and certainly have I know some thoughts on what Powell told us. I mean, you could make an argument that what he told us is what we already knew, but he did it with such force that clearly the market re-priced Fed rate hike expectations higher. Yeah. So, my question for you is, you know, did the market, actually two questions? Did the market interpret the message correctly? And is, you know, this sort of expectation now built into fed funds reasonable, or, or is it still not tight enough?

Dr. Jeffrey Roach:

Yeah, those are great questions, by the way. So, you know, you think about there are so many ways to make an error, <laugh> right? on the way up, on the way down, as you referenced on the previous slide.

And those of us that have kids know also firsthand that there are so many ways to make a mess, right? And so, it's certainly possible, you know, the Fed has talked about this, their dual mandate, they can emphasize one mandate over the other. They actually do that all the time. And it just doesn't always get the press, and it always doesn't last as long as it has in this current cycle. So, yeah, they've always said, hey, we're going to emphasize growth and on purpose. And now currently they're saying, hey, we're going to emphasize the inflation risk. You know, it, you could argue there's not much we learned from the speech other than, hey, we're serious now, take us seriously. And that was the point of the short but not so sweet you know, remarks that Powell gave, by the way, just wanted to highlight Jeff.

We don't talk a lot about this, but there are a lot of other very interesting speeches going on in this symposium. You know, central bankers from literally around the globe are there. And so, you hear from them. You also hear from a lot of academics all over the place. Some academics are more dry than others, as we can all remember from graduate school or college. But there's a lot of interesting things going on that don't make the press, by the way, they don't stay in five-star resorts. It's pretty bare bones. You have to watch a Mike McKee Bloomberg special he did several years ago where he toured, where they all stay. But looking at this graph, you know, we have a 50 basis point you know, expectation for September. And then, you know, 25s and 25s.

I think the new thing, given how serious the Fed is on fighting inflation, is that hey, they're not going to pause until maybe March. You can see that that's where the columns really peak and kind of flat line. Before, you know, we thought, hey, probably maybe February could be where they kind of, you know, pause and wait and watch and see. So, it's been, everything's been pushed out maybe a month or two. And then of course you can see the declines in the latter half of next year. But in the near term, 50 basis points, September 25, 25, November, December, something we've been talking about for a very, very long time.

Jeff Buchbinder:

Yeah. So that suggests that maybe the markets got it about right at this point, but certainly the market doesn't have a lot of confidence yet that it has it, right.

And that's why, you know, stocks may be in the near term are going to be a little bit choppy. So, here's the S&P 500. Of course, we had this sell off on the Jackson Hole speech. In fact, we said last week on the podcast here with Quincy Krosby that you know, maybe after failing at the 200-day, we would just go right back to the 50-day. And that's basically what we've done. Stocks are up, we're a little bit here this morning. We're recording this on Tuesday morning. So, you know, we'll see where we close here, but the 50-day is certainly support, but below that it's 3,900, which is the May lows. So that's the key number to watch here. Just, we're calling for choppy, but after we get through this seasonally weak period of September, which you can see right here, September, one of the weakest months of the year, historically, whether you look at 10 years, 20 years, post-World War II, even just highlighting midterm years, September has on average been quite weak.

So, this is not necessarily a great time to look for a rally. However, look what's coming around the corner, October, November, December, very, very strong historically, and even stronger in midterm years. So, we've talked a lot about that pattern. And we're getting closer. We're what about I mean, closing in on just two months, right? The two month mark ahead of midterm elections. So, the seasonal pattern we think will work and we'll have a nice Q4 rally, but in the near term, the market needs to get comfortable with inflation. It needs to get comfortable that it's got this Fed path, right? And then you know, can maybe start to make a rally here next month. So, that's some brief comments on the Fed. Let's turn to, on a related note, the inflation challenge, right? Also Fed related. There is a risk that the Fed is wrong twice, <laugh> right, wrong by being too late with the hikes and now wrong by hiking too much.

So you know, on this, we've got a list of a number of reasons, Jeff, that in, you know, or pieces of evidence that inflation is falling, right? That's right. That's right. Right. As the Fed is getting hawkish, I mean, they've been hawkish for maybe, you know, a couple of months here, but this is right as the hawkishness is really ratcheting higher. And this is right when we finally started to see some evidence. So, we have a list here, not even a complete list, I'll bring each one of these in one at a time, but a list of evidence that inflation is falling right as the Fed gets tighter, right? Right.

Dr. Jeffrey Roach:

Yeah. Maybe, the best ways is inflation is decelerating still, you know, above the target, but decelerating, and let me just briefly say relative to your previous slides, Jeff, you know, whenever we're in a point of inflection, markets will be volatile.

I think that's kind of the basic takeaway, you know, kind of that elevator pitch point that you want to take away from that. You know, that inflection implies volatility. So here we go. Yeah, expectations are down. You know, we can go through this list pretty quickly. Commodity prices. Think about oil. Think about lumber, right? That's down. The shifting away from goods services. Remember that pivot to services, goods, goods to services, that movement back and forth. So, think about durable goods prices have eased in the last several months. Supply chain improves. You've heard us talk about this for a very long time. I'm going to talk a little bit more about that in another slide. Money supply, as the Fed institutes its tightening process. Keep going there, Jeff, with the next bullet point. You know, Fed hikes, remember, you know, we're seeing now the effects in the real economy of what the Fed did in previous hikes, you know, two months ago.

Next bullet point is, you know, U.S. dollars. So that implies falling import prices, that's going to filter through to an easing of consumer prices domestically. Next one is higher mortgage rates, certainly cooling the housing market. And, you know, a lot of flux going on there. I don't know by the ways we said, look, we just, this is kind of a highlights. We didn't even talk about shipping costs have gone down, you know, times of shipping from port to port has gotten shorter. You know, all this stuff, of course, is setting us up for kind of that easing of inflation. So, if you go to that next slide, you can actually see the actual decline in prices. And I showed this before it's just worth, you know, talking about here just briefly, is, you know, from a core standpoint, if you look at durable goods, for example, they've started to ease back in February, we've started to see headline, now ease in July.

 

We got to wait a little bit till we get August numbers, but we already know August is going to cool as well from the impact that we've seen from, you know, more high frequency data. So if you go to the next slide, even just kind of moving this along, is to say, okay, if you look at from Friday's deflator number, which is the preferred metric for the Fed, you look at that top half of the, you know, the shaded areas, that lighter blue color, that's supply-driven contribution to inflation, that's roughly half of the 6% year on year gain in inflation in July. So, half of that is supply-driven. And so that's why, you know, we've talked about, you know, the Fed's tools do not address supply side. And I think that's why it's so important to keep on talking about that. Sometimes we feel like we're in a broken record, but I think clients can appreciate that when we talk to end clients, we say, look, you know, half of the inflation pressures right now are COVID-related, pandemic-related, reopening-related.

And so hence you could have some of that reversion and easing in the very near term. So go to the next slide. That's what I wanted to say about supply chains. And yeah, I'll tease this up briefly, Jeff, on just, okay, go ahead. Profit margins. Yeah, I'll throw out the profit margin conversation that we had in our Asset Allocation Committee meeting yesterday. And I'll leave it there and toss it to you to talk about corporate America.

Jeff Buchbinder:

Yeah. So, thanks Jeff. Just to wrap up the inflation discussion, I think it's frankly remarkable that according to the University of Michigan survey inflation expectations over the next year are down to 2.9%. So, I put that one first, that is hopefully we get that in a year. But that certainly has come way down.

I think it peaked at like four and a half. That's come way, way down. And certainly, I think good to be at the top of that list in terms of evidence that inflation's falling. So yeah, let's turn to corporate America. Yeah, I mean, you're right, Jeff. The profit margins, that was one of the keys that we wanted to watch this earnings season. And I would say that it's been as good as you could have hoped, frankly, to just have modest downward pressure on margins. And it wasn't too much pressure to prevent companies from meeting their Q2 targets, right? The final growth number for earnings in Q2 looks like it's going to be 6.2%. That's only a couple points of upside. But given the challenges that's not bad at all, I mean, remember before the pandemic, when the numbers just started to get pretty wacky, wacky in a good way, upside of three, 4% was normal, right?

So, to do that with supply chain challenges, with slow economic growth with a dollar that's at a 20-year high and has been surging, right? Cost pressures, inflation really intensified in Q2, all of those challenges, geopolitical challenges as well, let's not forget that. To still deliver two points of upsides, pretty darn impressive. Now we did expect estimates to come down, and they sure did, but frankly, I think just about everybody expected estimates to come down. But because margins hung in there and revenues were so strong, and frankly, companies are just doing a good job of managing costs, they didn't come down dramatically. So, we're still, the LPL Research forecasts are still below consensus forecasts. And in the case of 2023 dramatically so, I mean $8, $9 of S&P 500 profits. Now, keep in mind though, that the inflation reduction act is going to probably take two to three dollars out of 2023 profits.

So maybe we're really more like 241 at this point. If you adjust that consensus number but that's still six bucks above where we are, 235. So, we still feel good about those forecasts. And frankly, to miss those by any meaningful amount, we'll need a recession. Hope we don't get it. But that would be the scenario that would cause us to miss those earnings estimates. So, let's go to our last topic, Jeff, kind of rapid fire, which is on energy and is energy a buy. And, you know, we get into controversial investment to make, you know, with the ESG movement and all, but setting that controversy aside and just looking at sector fundamentals, frankly, it's more than fundamentals, it's valuations too with technicals as well. The sector looks like a pretty good opportunity.

We did a blog on LPLresearch.com last week. By the way, our, our Weekly Market Commentary this week is on earnings. You can find that on lpl.com. But the the blog last week, I believe it was on Thursday, highlighted energy as an opportunity. This is just relative strength. And you know, if you try to sort of build a case for a sector, I think, you know, it's the old adage of buy low, sell high. When you get a sector that's fundamentally strong, which we think energy is, and you get it on a dip, that tends to be a good opportunity. And look at what we've got with energy here. We had this pretty big you know, selloff in energy, relative strength came back quite a bit after the surge earlier in this year.

And now we're starting to make some more progress. So, if we can actually on this chart, maybe the scale isn't quite, is a little misleading, but if we just get back to the relative strength highs that we set in June, this is you know, another 15 percentage points of excess returns. The sector has outperformed dramatically this year, but we actually think it can continue to make a run. So, Jeff, what do you think about energy fundamentals here and oil? I mean, the supply is still tight and you know, we're not getting good demand out of China right now, but, you know, the demand story in the rest of the world's pretty good. Don't you think?

Dr. Jeffrey Roach:

Yeah, it's really kind of mixed. So, if you look at, you know, leisure travel and just the demand to move around and get out there, it's still there.

So, you know, that's from the consumer side, from the corporate side, of course, you know, manufacturing kind of continue to kind of recover and a little bit of a rebound as supply has improved. You know, for example, industrial production for autos has increased recently because this access to supply chips. So, when you look at industrial production, which tends to correlate with energy, you know, a little bit of upside. You know, one thing that maybe tampers my expectations a little bit, this came out from a Stanford economics prof recently. You know, given the hybrid work from home, there are billions of less commuting miles happening these days, <laugh> than, you know, before pandemic. So that's kind of tampering demand. But I think in the near term, there's a little bit of that upside as industrial production ramps back up.

Jeff Buchbinder:

Well, you helped with those commuting miles today, I know. And I'm going to start helping a little bit more here, before long. I had to recover from my hip surgery first before I was going to go into the office but doing much better and probably going to head in later this week or early next. So, this is a chart of oil. I mean, I agree that the, you know, the demand picture's not great. It's not you know, table pounding buy here for energy. But you know, the supply side, we certainly are getting some tight supply out of OPEC+. And in fact, we just heard recently from the Saudis that they may cut production back further to support prices. They said they're worried about recession. So, we'll see what happens there.

But you know, we also have tight inventories here in the U.S. We are exporting a record amount of petroleum products. The last weekly report on inventories was a pretty big draw which, you know, provided support for this latest bounce. So, you know, now oil's kind of at this crossroads where the 50-day and the 200-day meet, the 200-day is still upward sloping, which we can't say about the stock market. So, you know, maybe oil makes another run back to you know, maybe not back to recent highs in the 120 range, but certainly we could see oil, you know, retracing maybe half of this recent decline in getting back to like 105, 110. We don't want oil to go higher. But the near term, especially with what's going on in Europe right now the near term outlook looks pretty positive.

So, you know, we try to be action oriented here on this podcast and give people ideas for how to manage portfolios. Here's an idea to look at if you know, if you either have no energy exposure or modest exposure, it might be time to look at it.

Dr. Jeffrey Roach:

From a, you know, big picture story. You know, you think about what's crimping supply, and that is just access to qualified labor to get, you know, to get down there. It's, it's one of the things to just, it's really important to watch the DUCs as they call d u c drilled, but uncompleted. And it's been interesting and kind of tracking, you know, firms that are, that are in the business saying it's a little bit challenging to get workers to provide, you know, the services that these energy producers need.

So that's, I think something to think about from the supply angle.

Jeff Buchbinder:

Sure. And something that's pushing the inflation problem in the wrong direction, right? Tight labor markets. So more labor can put downward pressure on inflation in a number of different industries, and certainly oil is one. So yeah, good discussion there, Jeff. We'll keep watching energy closely, but it looks like it's poised to make another run. So, let's wrap up by just looking at what else is coming this week. I mean, if you look at this list of big economic reports, I think your eyes immediately are drawn to the jobs report on Friday. Consensus is 300,000 new jobs on Bloomberg. And the unemployment rate is expected to remain unchanged at a very low 3.5%. So, I, you know, I guess Jeff, it's a good news is bad news, bad news is good news kind of market environment with everybody so focused on the Fed.

What do you expect on Friday?

Dr. Jeffrey Roach:

Yeah, I think we're looking for probably a sub-300. That's what I'm, you know, expecting you think about you know, that's still a big number historically, <laugh>. And I think it's important to put it in context, you know, so previous month, you know, over a half million gain in jobs, it's possible that some of those were double counted, you know, people holding more than one job, multiple job holders. But nonetheless, I think the big story that we need to see is, you know, an easing, a slowdown that's controlled and measured as the labor market cools. So, you know, going from, you know, 700,000 job gains in one month to 600 to 500, you know, if we're a little sub-300, that's, that's good news in that the economy in the labor market that is, is slowing, but it's slowing in a measured pace, not, you know, completely you know, contracting.

So, that's going to be important to watch. I think, you know, most important too, the Thursday morning claims numbers and it's just showing that there is indeed weakness. And of course, our call right now is a, you know, still probably a coin flip on recession in the beginning of 2023 or maybe the Q4 of this year. And so, we need to watch the labor market closely because that's going to help us identify and change those odds when we need to. The probability of falling in recession at this point, you know, I think we can eek out some growth in the third quarter and rising risks or Q4 this year than certainly even higher risks for Q1 next year. That's putting it in perspective, right? We're watching all these weekly economic indicators and, and market moves.

Big picture is, okay, what is this telling us about where we're heading and the forward-looking projection? So, there you have it, recession risks rising more in Europe than in the U.S., but clearly recession risks are rising.

Jeff Buchbinder:

Yeah, I think on the jobs market you know, something around 200, maybe even a little lighter than that would be fine. You know, still job growth, but slower and more evidence that the Fed is getting what it wants in terms of a cooling job market. But in terms of recession in the U.S. I mean the data that we've seen over the past couple of months, Jeff, I think is pointing to, you know, potentially, I don't know, 2% GDP growth in Q3, maybe even a little bit more.

Dr. Jeffrey Roach:

Yeah, for Q3. You know, we talked about this in a blog post recently that you know, retail sales adjusted for inflation, you got to do that on yourself, because yeah, they don't, census doesn't report it in real terms, it's nominal, but when you adjust for inflation, real spending grew in July.

So, you know, first, first month of the quarter we still have a little bit more to go. We shouldn't be you know, getting too excited yet for the third quarter. But clearly it does seem to suggest that this inflation eases consumers and corporations are still fairly resilient. And that should bode well for us to eke out some positive growth in the third quarter.

Jeff Buchbinder:

That's great. And as I've said before the Buchbinder family helped with some back-to-school shopping, which we continued even into this week. So, we're going back to school tomorrow here in Massachusetts. So, an exciting day, my girls are happy about it. Some kids are not <laugh>, but my girls are happy to be going back to school. So, thanks for that, Jeff. Good discussion. You know, especially that last segment, I think about the recession risk I think people should maybe not be so concerned about that right now, but maybe if we do get more weakness in the job market, that'll be something to look at for year end. So, we'll go and stop there. Thanks everybody, as always for listening. We greatly appreciate your support of the LPL Market Signals podcast. Thank you, Jeff. Another Jeff and Jeff show on the podcast. We'll be back with you next week for another one. Again, thank you all for joining.

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