We first became cautious on future market returns last March and have remained so ever since. Despite some countertrend rallies after the market peaked at 4,797 on January 3, 2022, we continue to believe that the inversion of the yield curve, aggressive Fed tightening, and the likelihood of a decline in corporate profits renders the chances of recession by the end of 2024 at about 3 in 4.
Having said that, the tape and the economic data over the past month suggest that a recession is unlikely to imminent. The recent increase in the Dow Transports is confirming the move in the Industrials and labor market data, whether it’s unemployment claims or nonfarm payrolls, are actually strengthening. Naturally, this puts the Fed in a difficult spot, especially as an institution that places great faith in the Phillips Curve to determine future inflationary pressures. It is difficult to see a cessation of Fed hikes if one takes the central bank at its word based on its own stated commitment to reach its 2% inflation target.
Perhaps it’s a foolish consistency on our part, but we believe that investors with intermediate or longer-term time horizons remain cautious and favor shorter-duration equities that can return money to shareholders. The principal reason for this point of view rests with current valuation. Both the current level of inflation and the likelihood of further Fed rate hikes make the S&P’s current 18.4x multiple in 2023 expected earnings of $224 look too rich given current economic uncertainties and our own economic forecasts.
THE BULL CASE:
1. M2 has grown by ~40% since Feb. 2020. The Fed has increased the amount of assets on its balance sheet by more than 100% since January 2020. Money growth works with a lag.
2. Meaningful price declines in growth stocks have already occurred.
3. Consumer balance sheets strong – personal savings rate 3.3% as percentage of disposable income (12mo avg.)
4. Companies are currently carrying high levels of cash on their balance sheets.
5. Job openings still plentiful.
6. Equity Risk Premium suggests that equities still have interest rate support. 7. Credit spreads remain tight.
THE BEAR CASE:
1. Levels of inflation above >4% put meaningful pressure on earnings multiples.
2. Aggregate earnings have been revised downward rapidly over the past six months.
3. The Fed is unlikely to ease soon. Fed likely to stay tight until a positive real Fed Funds is achieved.
4. M2 growth is -1.3% y/y. 3 Month Change Annual Rate -3.9%.
5. The Treasury yield curve (2s-10s) remains inverted.
6. Treasury supply likely to surge as funding costs reset at higher levels.
7. Higher input costs such as labor and commodities may negatively impact profit margins and slow earnings growth.
8. Little evidence Administration is backing off aggressive regulatory stance toward Financials, Energy, and Health Care.
Source: Strategas
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance or specific investments. Data provided by Refinitiv.
Sincerely,
Fortem Financial
(760) 206-8500
team@fortemfin.com
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