Market Insights

Yes! “Chair Powell” just confirmed this week — The Federal Reserve is no longer projecting a Recession in the US for the foreseeable future.

The biggest catalyst of the week is obviously the Fed July FOMC Meeting. I have 5 thoughts on it, especially on Jerome Powell’s comments at his post-FOMC press conference:

#1 — Rate Cuts may be farther off than markets expect.

In response to a question about how the Fed will consider the trajectory of disinflation as it weighs Monetary Policy decisions, Powell said Rate Cuts will be at least a year away.

While other comments he made reflected the Fed’s data-dependent approach regarding Monetary Policy, this one struck me as the Fed expressing a deeply convinced view.

Fed Funds Futures (FFF) currently discounting rate cutes starting in Jan 2024, with the highest probability outcome of THREE 0.25% cuts by July 2024. 

So I believe in Aug and Sep, we will see the market trying to digest the Rate Cuts “delayed” possibilities until the next FOMC Meeting, which will be on Sep 19-20, which fits the typical seasonal weakness in these two months each year.

#2 — Powell believes US Labor Market will weaken further, but the US economy should be able to avoid deep recession (common to past periods when the Fed raises rates aggressively).

Thanks to persistently high consumer demand and confidence, especially for services, Labor Market has cooled only slowly. This trend should continue, although the Fed does not see a sharp downshift in economic activity any time soon.

#3 — The US Banking system has settled down since the “SVB Shock”. Bears, Short Sellers and Fear Mongers are getting slaughtered.

Powell highlighted that this week was the 3rd Rate Hike since SVB collapsed back in March. This means: the “Banking Crisis” earlier this year has not fundamentally hurt the US Banking system and Economy.

Yes, credit conditions are tighter. But that’s what we’d expect as interest rates go up. Powell also highlighted that Banking sector profits are coming in strong during this Q2 earnings season.

#4 — Powell sees nothing inconsistent about the eventual Rate Cuts, but continuing to reduce the size of the Fed’s Balance Sheet.

He described both moves as “normalization”. The Fed Fund rate is currently restrictive, so reducing it as inflation continues to decline is prudent.

Conversely, the Fed’s Balance Sheet is still twice as large as pre-Pandemic Crisis ($7.6 Trillion vs $3.8 Trillion). Normalization will take longer to get there, aka Bulls should be patient with the Rate Cuts (back to #1).

#5 — The September FOMC Meeting could go either way in terms of another hike or another pause. Market is pricing in a “pause”.

Powell pointed out that the FOMC will have the benefit of seeing two rounds of monthly economic data before its next rate decision.

June’s better-than-expected CPI reading could be the start of a string of good news reports, or it could just have been a one-off improvement.

A more gradual pace of Rate Hikes does not necessarily mean skipping further increases to the Fed Funds rate at any given meeting.

Apart from my own thoughts, here are some other important comments made by Federal Reserve which I believe deserves your attention:

• We might be stuck in the “Good News = Bad News” cycle for a while. Although the resilience of the US economy in the middle of aggressive hawkish monetary policy is a “good thing”, it can also contribute to stickier inflation.

• The Fed believes Core Inflation readings are more important to watch for Rate decisions than Headline Inflation readings.

• The Fed will cut rates even with inflation stays above 2%, as long as it is heading lower at a convincing pace.

• The US housing market remains out of balance, and that “feeds” the sticky Inflation. The main problem here is that many homeowners re-financed their mortgages when rates were at historically lows and it makes no sense for them to get a new property and pay current (much much higher) market rates. The Fed pointed out shelter inflation will remain as a “problem”.

• Real Wage (inflation adjusted) growth is now positive. That’s great for consumers. But still, it can also “feeds” inflation (“Good News = Bad News”). The Fed wants to see a further softening in labor demand, aka Powell wants more folks to lose their jobs to control inflation.

Main Takeaway — The Federal Reserve accomplished the goal and gave the confidence that the market needed. But here is the “Catch”: Powell is facing an economy that turns out to be stronger than expected and could keep the Fed from hitting its 2% inflation target by 2025-2026. Additionally, Powell must know that the S&P 500 is now up close to 4% from Fed’s first rate hike (March 2022) of the current cycle. Keeping the optionality of further rate hikes is critical, both to achieve the Fed’s inflation goal and prevent a rightly optimistic stock market from heading into an irrational maniac.

Chart Of The Week

The #1 most important valuation metric to watch if you want to consistently beat S&P 500 over the long turn, is Corporate Profit Margin!

Legendary investor, Stan Druckenmiller, often repeatedly said in his letter-to-investors:

It took me many years to fully appreciate why he was right.

At the end of the day, Return on Capital (ROC) drives valuation. The components of ROC are:

• Asset efficiency (revenues/capital)

• Profit Margin (net income/revenues)

Companies usually can’t do much about their Asset Efficiency, because it is largely a function of industry and sector in which they operate.

They can, however, manage Profit Margin by focusing on productivity, maintaining a flexible cost structure, and constantly creating exciting new products that people love.

Businesses that can do that for years with consistent track records deserve a higher valuation (higher PE) than those who cannot.

So where are we right now in terms of Profit Margin?

This is the chart issued by FactSet, comparing sector-level Profit Margin of current quarter to 5-Year average:

Since 2021, Profit Margins have been declining consistently due to the post-Covid weak economy. It went from 13% in Q1 2021 to 11% in Q2 2023. Moreover, those current margins are only about the same as the 5Y average of 11.3%.

No wonder the S&P 500 is still 5% away from its ATH 18 months ago.

Margins have been solid (anything above 10% is still great), but they certainly have not been stable and need to growth.

If we look at the chart above, there are 3 key observations that can help us navigate where we are right now:

• While Technology’s current Profit Margins (22.4%) are down vs 5Y Avg (23%), they are holding in well. The last few years have been remarkably good for this sector, and yet they continue to show the second highest margins of any S&P group.

• Industrials sector are showing the best margin comparisons vs 5Y Avg (UP 2.5%), and the group remains cheaper than its 5Y average PE (19X vs 19.4X). This explained exactly why Industrial has been the most impressive sector playing the “catch up” game to the large cap techs.

• Health Care has the largest negative comparison in Profit Margins vs 5Y Avg (7.6% vs 10.4%). As we are heading into a new bull market, this is definitely a terrible sign for Health Care stocks investors

Main Takeaway — If the S&P 500 Profit Margin can hold 11% by the end of 2023 (which I believe it will), then we should buy every single dip from now until Christmas, because as companies get their cost structures under control, the next expansion is going to deliver even higher Profit Margins, which will increase structural valuation. And the market will be in a race to price in that possibility after digesting July FOMC meeting.

My Base Case — I believe Tech sector will be the main driver that accelerates the next Profit Margin expansion phase. That is why I am (and will be) heavily overweighting on Tech for the remaining of the year.

Key Data To Watch

▣ July 3, June ISM Manufacturing — BULLISH

▣ July 6, June ISM Services — BULLISH

▣ July 6, May JOLTS — BULLISH

▣ July 6, June ADP Employment — BEARISH

▣ July 7, June Jobs Report — NEUTRAL

▣ July 10, June Manheim Used Vehicle Value Index — BULLISH

▣ July 12, June CPI — BULLISH

▣ July 13, June Fed Wage Tracker — BULLISH

▣ July 25, May S&P CoreLogic CS Home Price — BULLISH

▣ July 25, July Conference Board Consumer Confidence — BULLISH

▣ July 26, July FOMC Meeting Rate Decision — BULLISH

▣ July 28, June PCE — BULLISH

▣ July 28, July Final Michigan 1-Year Inflation Expectations — BULLISH

Sell the News

“Elon Musk has replaced the Twitter logo with an “X” in a major corporate rebranding that comes as the company has struggled to attract advertising and is battling increased competition... The company plans to shift from being a text-focused platform to integrating more audio, video and payments features and is looking to woo advertisers as well as partner with broadcasters or payments groups... the company [plans] to wield artificial intelligence by working closely with Musk’s new AI company, xAI, according to Twitter. Twitter data could be used to train the AI models developed by xAI. In turn, xAI’s technology could be used to improve Twitter…” read more

“Facebook parent Meta Platforms reported its highest quarterly sales growth since 2021 as digital advertising continued to rebound, but the company also signaled that spending for its experimental metaverse unit would surge in 2024. The social media giant’s advertising revenue grew about 12% in the quarter, a turnaround driven by improved use of AI technology that has enabled better ad-targeting, after Apple privacy changes in 2021 cost the company $10 billion in sales…” read more

“Chipotle Mexican Grill on Wednesday reported quarterly earnings that crushed expectations, but the burrito chain’s sales fell short. The stock fell more than 9% in extended trading. Shares were up 50% this year through Wednesday’s close... Last quarter, Chipotle said it was done raising menu prices after hiking them earlier to mitigate rising labor and commodity costs. But executives seemed more open on Wednesday to another round of price increases…” read more

“Microsoft’s revenue and earnings came in ahead of Wall Street’s expectations in its latest quarter, despite a further deceleration in the growth of its Azure cloud platform as customers seek to increase the efficiency of their cloud spending... Microsoft said three months ago that revenue from generative AI was likely to add 1 percentage point to its Azure revenue in the most recent quarter. Azure growth slowed to 27 per cent in constant currency terms in the latest period, at the top of end of the company’s guidance but down from 31 per cent in the first three months of 2023 and 46 per cent a year ago. Microsoft has attributed the slowdown to efforts by customers to “optimise” their spending in the face of economic uncertainty…” read more

“Snap’s overall sales in the second quarter declined 4% from the $1.11 billion it logged in the previous year during the same period. The company said that it forecasts between $1.07 billion and $1.13 billion in total sales for the third quarter, while analysts were projecting $1.13 billion…” read more

“After 12 years, the price of Spotify Premium is increasing in the US. The subscription will now cost $10.99 a month, the company announced today. Spotify has charged $9.99 for its Premium subscription ever since its launch in the US in 2011…” read more

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