It is Changing to HIGHER Rates

It is always about the change. What is the pattern of the change that we see? Is there noise or do we see a consistent pattern emerging?

Looking at CME FED Watch Tool which has been significantly effective in predicting the FED’s rate hikes, we are witnessing a change to higher. In the chart we see an increasing probability for 50 bps and a decreasing probability for 25 bps.

Why the change! Per all the data, inflation has proven to be very sticky and resistant to going down to the ideal 2-2.5% range. Per Deutsche Bank, once inflation is over 5% it can take a decade for it to come back down. Furthermore, per the recent CPI, it is still RISING M/M. We had a deceleration especially in goods but the CORE is still rising and it is about 5.6% Y/Y and +.4% M/M which is very high. The broad based came in at 6.4% Y/Y & +.5% M/M. Next report is Tuesday, March 14.

Labor market is still very tight so it is difficult to have a recession near term with a strong labor market and this phenomenon is also a key contributor to higher inflation as services are a function of labor and employment. Of course things can change quickly. As business profitability reduces further due to compressed margins (add in higher rates to their levels of debt and capital) and reduced sales, they will reduce their costs and most likely layoff workers as there is less need for workers with lower output and volumes. Then with people laid off, they will consume less and not remain the “much needed” customers for these already dwindling business profits. Therefore, further business profitability deterioration. REPEAT.

We also recently had PPI report which came in HOT. +.7% Total Final Demand for January 2023 with +1.2% for Total Goods and +.4% for Total Services.

PCE is upcoming tomorrow, Friday, February 24.

There are 3 ways for Central Banks to reduce inflation:

1. Raise Rates

2. Reduce quantity of money through balance sheet reduction and tightened credit

3. Reduce government spending

The government has been massively spending and there is no sign of cutting back. Higher deficits at higher rates.

For Q4, the blended earnings is now at about -4.7% with estimates in double digits declines for this year. An earnings recession seems inevitable. Companies are buying back stock to help boost their EPS but how long can it last? They have reduced their CAPEX and future reinvesting for future growth. Look closely at guidance. Not very favorable. As investors we focus on future and it doesn’t look so bright right now.

Low to no growth should continue. Scale of growth depending on industries, sectors, companies. Companies in “edge” industries that require constant refi for capital will face the greatest hardships. “Essential” necessary aka inelastic industries are where I am focused. Medical, staples, bios, cybersecurity, value. Cash generators, good FCF yields, rising future guidance, rising or maintaining margins, increasing EPS, etc. “Select” stocks, sectors, industries and look for leaders.

This could last years. A rangebound slow grind is my thinking for now.

Fiscal and monetary policies need to be in alignment.