PreFOMC Wednesday Feb 1 Today
It is all in the language…Powell’s language that is. Per CME’s FED Watch Tool, 25 bps has about 99% probability so what we need to listen to is what and how Powell says it at his briefing at 2:30PM EST and how he answers the questions presented. I find a lot of value with how he answers the questions as those query his bank of thinking without a “script” per se. Unless those questions are also preplanned.
Financial conditions have loosened significantly as the market has rallied (SPX to 4100), HY credit spreads & mortgage spreads compressing amidst declining earnings, slowing growth, tightening liquidity, rising costs of debt and capital, higher deficit spending and government debt, persistently elevated inflation and CORE still rising M/M, etc.
However, we have a very tight labor market as a backdrop with unemployment at about 3.5%. Inflation is cumulative and still rising M/M. This is a problem.
NDQ rallied in January with its best month in over 20 years going into the FED meeting. SPX and IWM also rallied along with QQQ. As risk free rate rises so should the earnings yield for the indexes as valuations and price should come down. We need to be compensated with cheaper prices for incentive to take on risk as the risk free rate provides us a decent return at close to 5%. I have enjoyed putting my cash into T-Bills 4 weeks at rates over 4%. This to me has been the better option for rates of return/liquidity. Of course T-Bills are not “real” rates of return rather nominal as everything in life as we live in a nominal world with everything stated in nominal terms unless otherwise specified.
So SPX multiples (P/Es) are at about 18x which isn’t necessarily cheap. In my opinion it should drop to at least mid-teens to compensate for the higher risk free rates. The ERP spreads are currently very narrow and should widen upwards so SPX yields rise and, accordingly, prices come down.
Remember everything should be priced against the benchmark of the risk free rates. As they rise so should other earnings yields. Why would I pay more for riskier assets when I can have 4%+ risk free rate of returns?
Cost of capital is more expensive and earnings are declining significantly and may go negative as we most likely will experience an earnings recession (2 Qs back to back of declining earnings Y/Y). Regarding SPX multiples, even if we remove the top 6 or 8 companies with the largest MCs, SPX P/E doesn’t drop much maybe to 16 depending on your specific calculations. I am not going to argue the 1 or 2 points here as the overall theme is most important. The risk free rate over 4% and close to 5% is the driving force here!
Several cyclical sectors are experiencing declines and are the deflationary forces we are seeing. Used cars and other durable goods. Also, housing is declining but it seems likely that rents will not come down as quickly since mortgage rates have priced out a lot of families buying their homes for the time being. Therefore many are renting which will keep those prices elevated. It is basic supply and demand. Higher demand so prices will remain elevated and may even increase. We shall see. Of course things can change rather quickly in this environment of many moving parts.
The tightening ERPs make for expensive equities or SPX earnings yields will adjust upwards so prices come down.
The FED’s goal is return to 2% which does not seem likely any time soon. We shall see today!