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Good morning. I’m not a luddite, but virtual reality headsets seem like something from a dystopian future, as envisioned by film director David Cronenberg. Especially when they cost $3,500. That said, I’ve often underestimated Apple. Email me with your grand vision of the future of computing: firstname.lastname@example.org.
Something big has happened. Concrete: nothing
The most important thing that has happened on Wall Street in recent months has been a reassessment of inflation, and with it the likely path of Federal Reserve policy.
The market-implied federal funds rate for the end of this year has risen steadily since March. Three months ago, the broad consensus was that we had seen the spike and that rates would soon begin to fall. Now the consensus is that six months from now, rates will still be where they are — about 5 percent. Here is the evolution of the Fed Funds interest rate implied by the futures market for December 2023:
But it is wrong to characterize this as something that happens. What it really is is something not happen, something everyone thought would happen. The sharp fall in expectations for key interest rates at the end of the year in early March was due to a banking crisis appearing to be imminent. What has happened since then, as reflected in the rising trend on the chart, is that the crisis is not going to happen – and while we’re at it, there won’t be a debt ceiling crisis either.
As a result of these two non-events, policy expectations have simply returned to somewhere around the level they were before Silicon Valley Bank mismanaged itself and went bankrupt. And of course there’s a third thing that didn’t happen, perhaps the most important non-event of all. The very rapid increase of the policy rate by 5 percentage points by the Federal Reserve has not broken the US economy.
This last point is worth dwelling on for a moment. The Fed’s rapid tightening appears to have dampened core inflation somewhat (core CPI has moved from 8-ish percent year-on-year to 5-ish percent) and kept inflation expectations well anchored. Meanwhile, unemployment remains near pre-pandemic levels and even near multi-decade lows.
As Unhedged has pointed out, there are significant weaknesses in the periphery of the economy. But to my surprise (and I think to the surprise of most people) while we are going through an economic slowdown, there are no signs of crisis or recession in the overall economy. Revenue is a good example. According to the first quarter FactSet’s revenue monitor, earnings of S&P 500 companies fell 2.1 percent from the previous year. That’s not great, but just two months ago the analyst consensus was for a 7 percent decline. In line with the broad economy, earnings have been positively surprised. Accordingly, earnings expectations for this year and next year are starting to creep up after a long period of decline.
Where does this year of non-events leave us? The consensus on Wall Street, as far as I can tell, is that what we are experiencing is a delayed recession (or near-recession). There will be a day of reckoning. That day can take different forms:
The slowdown visible in certain parts of the economy and certain economic indicators will be reflected in falling corporate profits. This widely held view is usually expressed in a two-axis chart where a chosen indicator (ISM manufacturer surveys; the yield curve; and index of leading indicators; or whatever) is plotted against earnings growth, showing that earnings usually the chosen indicator follows, but that the two have parted ways. The implication is that the normal relationship will be restored through a drop in revenue. Here’s my favorite example of this kind, as presented by Ryan Grabinski of Strategas, who compares S&P earnings to South Korean exports, which is a global activity tracker:
It may be that the economy has been supported by the build-up of household savings in the pandemic era, and the wheels will finally come off when those savings run out. A recent paper of the San Francisco Fed estimated that at the current rate of burn, the surplus will be exhausted sometime around the fourth quarter.
The problems could arise when companies have to refinance their debt at higher rates. There is a so-called “maturity wall” of high-interest debt due next year. According to Morgan Stanley, $260 billion of US high yield bonds will fall within their 18-month “refinancing window” in January. That is more than double the current total. The cost of debt rises, margins fall, hiring stops, unemployment rises. recession.
So much for the nasty, left tail of the distribution of outcomes from now on. What about the lucky right tail? It’s easier to explain: inflation continues to fall as the year progresses, the economic slowdown remains soft, and the Fed is slowly and deliberately lowering rates starting next winter. In other words, nothing happens.
A brief and possibly obvious note on the sexy six tech stocks
The other big thing that will happen in the markets this year is the massive outperformance of six big technology companies, which accounted for essentially all of the positive returns in the S&P 500. The sexy six (yes, I’m trying to live up to that name) from Alphabet, Apple, Amazon, Meta, Microsoft, and Nvidia have been treated (in Unhedged, among others) as a unitary phenomenon, largely driven by AI hype. But there is an important distinction to make between them. A table (data from S&P Capital IQ):
Earnings estimates this year are flat or lower for all companies except Meta and Nvidia, where they have risen quite a bit. Valuations are up at all companies except Nvidia, where the P/E ratio is up a modest 15 percent.
This simple exercise makes it clear that the sexy six are heterogeneous, and their future return is likely to be as well. Alphabet, Amazon, Apple and Microsoft are experiencing a valuation increase. Nvidia is undergoing a rapid reassessment of its near-term earnings outlook. Meta is a bit of both.
A good read
I have written approvingly of the royal family’s attire. But clothing aside, I have a lot of sympathy for this man.