Who Is Right: The Fed or the Market?

Jeff B (00:00):

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

Dr. J (00:10):

Hey, doing very well. I'm glad you introduced me on the important disclosure slide. Is that like a sign or something that I need to start reading this?

Jeff B (00:20):

You're the one that's more likely to say something that gets us in trouble, so I'm going to match your comments with that disclosure slide. Yes. very good. <Laugh>, you walked right into that one. So, thanks for joining us. It is April 3, 2023, as we're recording this Monday afternoon. Here's our agenda for today. The usual market recap, S&P 500 has now risen three consecutive weeks. So, we'll look at the S&P 500 chart. We'll also talk about the latest Weekly Market Commentary that's available on lpl.com. And Jeff, you wrote most of it. It was a team effort between the Jeffs.

Dr. J (01:02):

That's right. That's right.

Jeff B (01:03):

It's "Who's Right, The Fed or the Market?"

Dr. J (01:06):

We'll dissect that in the coming moments.

Jeff B (01:10):

That we will and an interesting discussion. No doubt. I suspect you're going to talk about whether the Fed's going to cut rates this year or not when we get there, but I'll just leave that hanging. Next April showers may not be in the forecast, so we'll just look at a couple of seasonality studies to make the case that maybe this little run we've had has more legs. And then finally, week ahead jobs report on Friday when the market will be closed for the holiday, and then the ISM. I think probably those are the two potentially most impactful or market moving reports. But if I miss one, Jeff, you will tell me. So, starting with the market recap, equities globally, the first thing that you'll notice here is what a strong week it was, right?

Jeff B (02:02):

S&P 500 up 3.5% for the week, despite ongoing concerns about bank stress. We also had a strong week outside the U.S. particularly in Europe. And you can see the, you know, Euro STOXX 600 up over 4%. You know, Jeff, I'll go to you on this. You know, Europe's market continues to do really, really well. A little bit of this is the dollar, but it's not just currency translation. Have we gotten economic news out of Europe that justifies this strength? Is there something going on under the surface, do you think?

Dr. J (02:43):

Well, I think some of the numbers may be skewed a little bit with the base effects. So, you know, relative to where the European markets were, say you know, 2, 3, 4 months ago relative to the U.S. I think one of the things though, you look at Germany, France you look at Spain, more developed side of Europe, and you know some things have been surprising to the upside. And you know, perhaps we're not going to have that nasty recession that seemed to look all but inevitable when we were, you know, looking and analyzing things just you know, going into the Q4 of last year. So, I think there's perhaps some, you know, some stability at least starting to emerge out of Europe. So, that's good news.

Jeff B (03:29):

Yeah, it's, it's debatable whether the U.S. market priced in recession, but I think it's less debatable <laugh> that Europe did that. Maybe they haven't had one yet, but they've certainly braced for it over there and that became consensus certainly late last year. And then falling natural gas prices have allowed that economy to hang in there really well. I guess, you know, maybe had less strength in Asia, certainly you know, ongoing U.S. China tensions that we're going to have to live with for quite some time. Turning over to the sectors, Jeff, I mean, we had some really big gains in some of the top sectors last week, mean 6% plus in energy, you'll see on the next slide, that oil was up about 9% last week, and is adding quite a bit to those gains today.

Jeff B (04:19):

As we're recording this last check, I think crude was up about 6% on the news that OPEC+ was cutting production unexpectedly. So, you know, energy led. But we had you know, pretty solid gains from consumer discretionary, from materials from real estate. You know, tech was a market performer, but still up you know, over 3%. So, really across the board strength here. I think the only thing that really jumps out as an outlier is if you look at the one-month column and you see what's happened to financials, right, down 9.6% over last month, clearly an outlier.

Dr. J (04:58):

Yeah, the one thing I'd add too, Jeff, is, which is impressive when you think of what, what markets were communicating to us prior to some of the challenges on the West coast, and that is you go to the six-month column right there in the far right, and you see the underperformance on financials being in, you know, high single digits. But pretty much a lot of these other sectors were in double digits. So, some of the challenges that the financial services industry has had independent of, you know, the Silicon Valley challenge, you know, clearly, I think this communicates that point that there's been some challenges in financials even before this mini crisis, if you will.

Jeff B (05:45):

Yeah, absolutely. I think it's worth pointing out that even though tech was a market performer last week, the mega cap techs have been supporting this market really all year. I did the math and of the 7.5% gain in the S&P 500 during Q1, that's total return, over six points was from the mega cap tech names, right? We're talking about, you know, Facebook, Google, Apple, Microsoft et cetera. I threw Tesla in there. We'll call that a mega cap tech name. You just need the eight, the top eight contributors. They're all tech or tech adjacent. And that was pretty much the entire gain in the first quarter. Now, our technical strategist, Adam Turnquist, tells us that the breadth is okay, right? But certainly, the leadership has been in mega cap tech land. So, turning to fixed income and commodities, you know, we were just having a discussion at our investment committee meeting about how interest rates or bonds are tougher competition for equities these days.

Jeff B (06:55):

And so, you know, if you just look at the one-month column, the broad bond market benchmark's up two and a half percent, right? So, even though the stock market's done better you know, if you can get that kind of return in a short period of time from the bond market, it makes the decision between stocks and bonds a little bit tougher. So, I also I mentioned oil. You don't see oil specifically on this table, but energy up 4% last week. That was, you know, oil doing quite a bit better, and natural gas doing worse. It's been a sharp bounce back, crude oil is over $80 at last check, and certainly has you know, people wondering if we're going to get a little bit of an inflation pickup, right? And this is where we get into your world, Jeff, as our Chief Economist, are we going to get a little bit of inflation if oil keeps moving higher, that's potentially going to tip the Fed maybe toward an extra rate hike.

Dr. J (07:53):

I think to answer the question, I got to set the stage just a little bit, and that is, you think about, you know, energy and you think what we say is good for an energy sector, a good run, i.e., prices going up, might truly be bad when you're thinking about another part of the broader equation, right? High energy prices, greater risks of slowdown in terms of, you know, general activity. So, specific to your question, Jeff, about the, you know, the oil price question, you know, so we had, you know, a spike in prices. We actually wrote about this for some of our client directed communications. And that is, you know, you think about where we are as a services-oriented economy, now, today, the modern economy relative to where we were in previous cycles, previous decades, where we were a little more manufacturing oriented, or at least that was a larger share of the overall economy.

Dr. J (08:52):

So, you think, okay, eventually, if in the services-oriented economy, yes, higher energy prices will still be a problem, but it takes a little bit more time for it to pass through, right? So, you're not thinking of the you know, the more direct effects and of costs of manufacturing. Now, granted, if you break it down at sectors, certainly the transportation sector is going to feel a little bit more the pinch of higher prices there in the crude oil markets. But it's very possible that this this will be somewhat short-lived. OPEC+ hiked, I'm sorry, they responded to the slowdown in the macro environment by cutting production, hence the spike in prices. But I think it's just an early move toward what we're all forecasting, and that is a global slowdown. So, that forecast of a global slowdown, I think is really, you know, that's going to come a little bit later. I don't know if it's going to cause that much of a problem in the very near term when, you know, Fed meets again, inflation pressure is still elevated. It's mostly in that services sector, core services ex housing that we'll actually talk about in a few slides from now.

Jeff B (10:13):

Absolutely. Yeah, inflation's certainly part of our presentation today. So, let's look at the S&P 500 here. We had a nice breakout above the 50-day moving average. You can see that. I priced this a few hours ago, so it might be off a little bit. But, you know, generally speaking as you break above these moving averages, it tends to be positive technical development. And then, you know, I'm also starting to see the slope of these averages tick a little higher. That's certainly positive. So, you know, from just a pure technical perspective, we still like stocks here and we're still you know, recommending overweights to equities relative to target in our Strategic and Tactical Asset Allocation Committee. I will say though, that, you know, breadth, we're getting some questions about breadth because the media's talking about how just, you know, six or eight stocks are driving the market.

Jeff B (11:13):

That's true, but that doesn't mean that, you know, the rest of the stocks aren't participating, they're just not as big a drivers, but collectively the majority of the S&P 500 is you know, actually above its 50- and 200-day moving averages now. So, let's turn to the main topic for today. Jeff, who's right, the Fed of the market. This is the Weekly Market Commentary for this week on lpl.com. You used a few charts here, so I'll just turn it over to you to walk through these.

Dr. J (11:44):

Yeah, yeah. So, so thinking about, you know, where we are in the cycle, you know, we really could drill into that chart you just showed us just a few moments ago with the S&P, and that is, you know, from October, those lows of October, every kind of mini cycle downturn in equity prices, you know, you're getting a little bit higher lows, right? The bottoms are getting a little bit better and better. So, you're seeing clearly the 50- and 200-day moving averages moving up. And the point, I think in all that is to say that, you know, we're expecting the economy to slow further from here. Bottom line is because of that economic slowdown, we expect inflation to be much better. More, I think, more conducive for, you know, the stock market to respond by that.

Dr. J (12:36):

And one of the pieces of the pie that you want to kind of put together here, thinking about where the macro environment is, and that is, you know, look at the labor market, the labor market is going to be, an always has been, a key component for how the NBER, the National Bureau of Economic Research, looks at business cycles. Clearly, the labor market is one of the driving forces for, you know, growth in real disposable income and purchasing power, ability to spend on the consumer side. And I think the key that's really kind of emerging with this chart that I show you here, and this is from the job openings and labor turnover survey, so we call it the JOLTS report. We shorten that up for obvious reasons, not having to say the whole phrase. And the JOLTS report basically reveals to us that this is, you know, right now, in this stage of 2023, moving out of Q1, going into Q2 now, firms are now responding, cutting workers, not necessarily just for cost cutting reasons, that's your orange line.

Dr. J (13:42):

They've been doing that for a long time in this recent post-pandemic economy. But you see the blue line there, and that's basically indicating that firms are saying, the reason why we're laying off people is because we're actually seeing a slowdown in demand. And that's in some ways this is the kind of thing you want to see for an economy that should expect lower and decelerating rates of inflation. So, I'm building the case basically to say, hey, in the overall theme markets, I think have it right in that the Fed will cut by the end of the year because the economy is slowing and hence inflation is slowing. So, we can go to the next slide. That's just kind of the big takeaway for those that want to drill in a little bit deeper you can go to LPL.com, the main page there, and under the press releases, there's Weekly Market Commentary link, so you can read all the commentary here.

Dr. J (14:38):

But here in the very, very near term, and this is kind of the challenge, Jeff, that policy makers are working through, and that is, you know, we're slowing down as an economy, yet the services side, the sticky side of inflation, still seems to be elevated and persisting and frustrating, you know, the markets and the Fed looking at, you know, how the inflation rates are matter for the, what we call core services, ex housing. So, you think about you know, financial services, think about transportation services. We just referenced that as it relates to energy prices. Well, the point is that one of the reasons why services inflation is staying elevated is because there's still this retooling and recalibrating going on between how consumers spend their money, you know, pandemic. It was this shift away from services, a shift toward goods.

Dr. J (15:39):

We're all going on our Amazon apps and, you know, buying stuff. Well, we're finally seeing maybe, you know, this emerging behavioral shift of saying, okay, we want less stuff, we want more experiences, though. And hence that's where you're seeing this upward bid on prices for the services side of the economy, because everybody's still clamoring to make up for time lost. You know, we've bought our things, now we want our experiences. So, this is, it, we're getting a little bit closer to pre-pandemic norms, but it's going to be a little frustrating from an inflation standpoint, right? If everybody's clamoring for the cruise or everybody's going to go do their trip to the amusement parks you know, you can keep with, you know, more and more analogies. The point is that that price action will respond by saying, all right, we got to allocate these scarce resources.

Dr. J (16:37):

Hence, you'll see prices rising as more and more people are clamoring for that and releasing some of that pent up demand. That's going to show up for a little bit longer. But I think we're at the tail end of seeing those core services, ex housing, inflation being so elevated. So go to the next slide. And that's basically showing you that, you know, in some ways the Fed is getting tighter financial conditions, but just not the way that they expected to get it, right. The Fed is saying, hey, we're hiking rates, therefore we're going to see tighter conditions, and therefore we're going to see inflation cool. And it hadn't been happening, and it's been frustrating many portions of the markets. Well, we have a mini banking crisis, certainly not widespread, but it was enough of a challenge to actually tighten financial conditions in a way that, you know, perhaps might actually finally cool the inflation component.

Dr. J (17:39):

You know, again, not as the Fed expected. What this chart is basically saying, you know, the shock to the system that we had in in the fixed income markets a couple weeks ago was really quite historic, even when you compare it to the great financial crisis. So that's all this chart is basically revealing to you is basically saying, you know, you think about this week to week change in two years, two-year Treasuries. And, you know, we clearly remember those days, those that were in the business back in the day, in the 08 kind of great financial crisis era where there was a lot of volatility, a lot of uncertainty, partially because of fundamental cracks in the system. Well, you look at what happened just in the last two weeks, by the way, you see that downward spike there, as of today, that has recovered.

Dr. J (18:30):

So, don't be misled by this graph. You just can't see the detail of you know, the daily detail here. But you can see that, you know, relative to even previous periods of stress, you know, the banking crisis in this very focused area of the financial services sector, you saw a pretty extreme move in yields. And that clearly denotes some kind of, you know, cause for concern, cause for, you know, tightening conditions. When we say tightening conditions, by the way, Jeff, you know, make sure our audience understands this. It's very basic in the sense that when you see tighter conditions, that just translates to less easy money as it were, and a most likely response by consumers to kind of pull back, retrench, be a little bit more conservative with their spending, and thereby, again, another I think another factor to say that inflation is definitely set to cool.

Dr. J (19:34):

So, before we leave this, again, kind of a quick shout out to going to the lpl.com website for more detail on this, this is a little bit of a teaser, but I think, you know, where do you put your stake in the sand? The point is, by the end of the year, inflation is going to be below 4%. It's going to be, you know, in the mid, maybe upper threes, inflation's cooling, the economy's cooling. Certainly, going to be good news for markets when we can finally see convincing data come out of that. And so, hence going back to the question at the outset of this little section where we're saying, okay, you know, who's right? Is the Fed right saying they're going to keep hiking and they're going to keep those rates elevated? Or is the market right? Market's expecting the Fed to cut at least a couple times by the end of this year, 2023?

Dr. J (20:22):

And who's right? My vote. I think the markets are right. And I think you know, when I laid the base case here for a slowdown in inflation to cool, I think markets are right. And the Fed's dot plot is perhaps a little bit, will become a little bit stale, as it were with that forecast. So, there you have it in terms of you know, where we think you know, equities might, again, you know, they certainly respond favorably when the Fed finally communicates and you know, arrives at the end of their rate hiking campaign.

Jeff B (21:02):

Yes, stocks tend to like the end of a Fed rate hiking campaign, and they also tend to like lower interest rate volatility. So, we think we're going to get both of those things over the next several months, which keeps us you know, in the bull camp, we'll call it cautiously constructive bulls, not table pounding bulls by any stretch, but we still like stocks here. So, we're putting your voice to the test here, Jeff. I know you had to talk a lot last week <laugh>, but keep going and explain what our viewers should be looking at here with regard to this inflation heat map.

Dr. J (21:37):

Yeah, yeah, that's exactly right. And again, you know, a good point, Jeff, you kind of added to the takeaway here, stocks tend to respond favorably to the end of a rate hiking campaign. And I guess the corollary to that is the markets definitely respond favorably when there's lower volatility, interest rate volatility, so clearly, you know, a good thing. And you know, I think, you know, we've kind of hinted at this kind of even more specified line item and inflation, this core services ex housing component that's on the bottom line there. And you can see just a real simple heat map, you know, if you're reading from left to right, you know, what you want to see is what we're seeing in the first, you know, three or four, five columns or rows here, right?

Dr. J (22:27):

You see dark red in June 22, and you're eventually getting to green in February 23. That's what everybody's wanting. And of course, you go farther down in this low matrix and you realize it's not really showing up in every line item. I think what it does visually is it explains, you know, to our audience here, that this is exactly why we talk about how inflation components of rent and housing tends to lag the rest of the economy. This is the case in point, right? You go to the middle of the chart, the rent of primary residents and owners' equivalent rent there you know, we're going from green to red, everything else is red to green. It's just because that tends to lag it. This is no surprise, this actually does this in previous cycles. So, it's not one of those things where we want to say, oh, this time's different. This is just normal and it takes time for the impact of new leases and new rental agreements to kind of start showing up a little bit weaker. And we do expect, you know, certainly by the summertime, that this entire chart will be a lot more green even as you're reading from left to right.

Jeff B (23:45):

So, my takeaway from this is to not get too frustrated if we see, you know, kind of a leveling off of the inflation readings, the year over year readings, right? Kind of a plateau, but eventually the you know, those, the real time data we're seeing now will flow through and we'll get that kind of fall dip to get to that kind of mid threes number that you alluded to, Jeff. So, yep. Yep. Better inflation days ahead. It's just, it's not going to be a straight line down because of these lag. So, still a positive story for equities. Speaking of positive stories for equities, let's talk a little seasonality. This is a little more than seasonality, I guess, when I get to the next chart, but this is the kind of the basic seasonal chart, Jeff, which just shows, you know, how on average the S&P 500 has done in each calendar month.

Jeff B (24:41):

And you see here the batting average for April, 71% over this really long-time horizon, and then the average gains, one and a half percent, those rank second, well, second or third, depending on which metric you use. But the point is April is a very good seasonal month. So, there's certainly, we would argue, you know, better than 50/50 chance that, you know, we'll be at a double digit return by the end of April. So, this next slide, because we're already up, you know, 8% give or take right now. So, this is even more powerful. This just, it's a simple study, but I'll just, I'll set it up. If you look at down years for stocks, and we had one last year, you can see here, 2023 the S&P 500 was down 19%, right. After down years,

Jeff B (25:40):

if you have an up first quarter, then you tend to see a gain in April, and you tend to see a really solid gain in the subsequent nine months. So, I mean, these numbers are really impressive. Now, these studies, you know, you always give the disclaimer, the sample size isn't huge, right? And this could be the first time after 10 that this doesn't work, <laugh>, but we would say more likely than not, this market will go higher between now and the end of the year. And this is at least one piece of evidence that that's likely to happen. So, once you get that up first quarter, we got that this first quarter, right, up over 7%, the average gain for the rest of the year is 16% and you're up every single time. So, boy, there are a lot of studies like this, Jeff,

Jeff B (26:35):

that tell us stocks are going higher, but this is about as compelling of a study as I think I've seen. Maybe the other one that's really compelling right now is the midterm election year lows tend to be followed by 30% gains, and we've done about half that already. The batting average for, you know, one year gains off of midterm year lows or even off of the midterm election itself is pretty much a hundred percent. So those are compelling studies too, but boy, it's hard to bet against this even though there are a lot of bears out there. What do you think?

Dr. J (27:08):

Well, you know, it's interesting when you think about you know, the intense challenges in some of those years, think about 2019, right? The prior calendar year, 2018, was negative, right? As you're showing 2019 is positive, you know, 2019 was a year where the economy was slowing, the Fed actually cut rates, right? And we had challenges on, you know, trade wars and what we were doing you know, with some of the tariff activity. And so, I think that's kind of compelling when you think comparing those previous years with where we are now, you know, we certainly have a lot of headwinds, right? Russia, Ukraine is still a challenge. You got some other headwinds and 91 by the way, another example where, you know, there's some slowdown in growth activity, maybe coming out of a recession. So, it's still, you know, when you put the numbers in its macroeconomic context, you can still kind of make the point that this is a legit way of looking at some of the numbers and some of the upsides, even as we look at 2023 going into Q2 and on forward.

Jeff B (28:23):

Yeah, you know, we were down 25% at the lows last year peak to trough. So, you could make the case that that priced in a mild recession, and we got something close to that maybe last year. And now you know, we're in the recovery phase, that is certainly a reasonable scenario. So, we're not, I mean, we don't want to dismiss the risks here and a lot of people are pointing out that the S&P 500 bottoms typically during a recession, right? And then we might get a recession in the next six to 12 months. So therefore, you know, maybe you have to go back to the October lows. Well, not so sure, not so sure. Maybe the, you know, maybe whatever we were going to get that looked like a recession or maybe it wasn't a recession, whatever it was, maybe we got it already and we're just going to muddle through and kind of bump along here.

Dr. J (29:19):

Yeah,

Jeff B (29:20):

I think that makes sense to as a scenario, it's not a tail scenario. I think that's probably as likely as the you know, the downside scenario where we just have a recession and stocks drop 25, 30% from here, which is the, you know, the historical average drop in a recession.

Dr. J (29:44):

That's what we were talking about in our earlier meeting here as a committee. You know, perhaps markets got that head fake, two consecutive quarters negative growth in 2022. Not a recession, but the head fake, as I was calling it. And you know, those October lows were pricing that worst-case scenario. And perhaps we might have that slowed down, might have the recession, but it's not the worst-case scenario that was already priced in in October. So, just to underscore the comments you just made, Jeff.

Jeff B (30:15):

Yep, absolutely. We got a wall of worry we're climbing. So, this week it's payrolls week, you know, even though the market's closed on Friday, we're getting that data point, Jeff, that's probably the biggest number of the week. I mean, we already got the ISM, it was good for the folks worried about inflation, but it was not good for those folks looking for growth. What are your takeaways from the ISM and then what should we watch for in the jobs data this week?

Dr. J (30:43):

Yeah, so I think, you know, if you could get what you want, we would want this very predictable slowdown. It's almost like the predictable recession as it were. So, you know, the manufacturing report on business was below 50. Anything below 50 just means that it's contracting relative to the previous month. I think it's important to remind the listeners on that. That's the whole point of that 50 mark, the line in the sand. And so, you know, the decline in factory activity, was the lowest since May 2020. Again, we're not a manufacturing economy, we're a services-oriented economy, but this does help, I think build the case that you know, the economy is slowing, somewhat measured as it were. And then we'll get the services component on that report on business on the fifth, we have it highlighted there, ISM services to report on business, but it's all about Friday's job numbers.

Dr. J (31:48):

So, what we're wishing for, what we we're hoping for is, you know, a measured slowdown, a measured decline in, you know, in the job market, you know, you don't want surprises, right? No one likes surprises including, you know, markets, they don't like surprises. And so, you know, consensus is still pretty hot above 200,000 expected for the month of March. I'm a little bit on the low end of that. I think it's going to be even sub-200. We're talking about, you know, a number of survey data that suggests, you know, the job activity, the hiring activity is slowing and cooling. So, you know, that's exactly what we want to see. We want to see this measured slowdown, but that's going to be the big one. I think, you know, there's still a lot of concern on wage pressure, right? That's adding some of the upside on inflation. So, if you see wages start to cool down, that's going to cool down, you know, your real disposable income from the consumer base. And so those are the numbers to look for and we'll see how that happens. But yeah, you're right, markets are mostly equity markets are closed on Friday, Good Friday there. But still have economic data still, still work to be done. Data coming out.

Jeff B (33:12):

Interesting that you think payrolls might come in a little bit light because that has not been the trend, right?

Dr. J (33:20):

We have been surprised several months in a row.

Jeff B (33:24):

<Laugh>, yes. And I, I think payrolls have only missed maybe once or twice in the last year. So, it's been a pretty steady string of upside surprises. So, you know, I'm not challenging you on that, but that would be a change in what maybe markets and pundits are used to seeing. Yeah, so we'll see. Still 50/50 on a Fed rate cut or rate hike rather in May roughly, based on the fed funds futures, maybe a little bit more in the pro cut camp, but if we get a soft payroll number, you're certainly going to see that go back down to 50/50 or maybe even less so. Thanks for walking us through the data for this week, Jeff. And thanks for joining. Certainly, we had a lot of economic content, so it was great to have you on. So, thank you as always.

Jeff B (34:16):

Thank you. Thanks Jeff. So, thanks to all our listeners for joining us again on another Market Signals podcast. Just always fun to do this. Everybody join us next week for another edition. We will see you then. Have a great day, everybody. Take care.