The Mechanical Bull Market

February 15, 2023

The Mechanical Bull Market

Simple question: How is the economy doing?

Answer: It is complicated.

After the Federal Reserve hiked interest rates again (but less than last time) and all the market volatility, it is a good time to talk about the economy.

Inflation has been falling since summer

Inflation fell for the seventh straight month in January, bolstering evidence that it peaked last June at 9.1%.

However, inflation is still exceedingly high, and its impact is being felt across the economy. Have you bought eggs recently? Up 70% since last January!

The jobs market is still strong

The latest January jobs report was a blowout, coming in ahead of the data that Fed economists expected. The economy added over 500,000 new jobs, and the unemployment rate fell to the lowest level since 1969.

You can see in the chart above that most industries are still actively hiring, suggesting that Fed actions still have not slowed the desire for workers.

The economy shrugged off recession worries in Q4

Despite all the recession doom and gloom, the economy grew 2.9% in the last three months of 2022.

However, consumer spending weakened slightly, indicating that Americans might be trimming expenses. Since consumer spending accounts for 70% of economic growth in the U.S., it is a warning sign we are tracking.

We see a few takeaways about the current state of the economy

But before we dive into them, I want to point out two important caveats about economic data:

Much of the initial data we see in the headlines is based on preliminary estimates that get revised later as more data is processed. These big data bureaus try to balance releasing data quickly enough to be useful and getting the complete picture.
Seasonal trends often impact data that can cause spikes or “noise” in the results. That is why we look for trends rather than single data points.

Here is what I see:

Despite tech layoffs and gloomy headlines, many sectors seem to be still going strong, at least job-wise. So, while adding more jobs is good, the increase in wage inflation is bad.

Interest rate hikes are not slowing growth as much as the Fed hoped, though inflation shows a downward trend. We believe the Fed will raise rates twice more in the first half of the year.

While recession fears are real and based on solid concerns, it does not look like the economy has hit the skids yet. However, we think the first quarter GDP (reported in April) will be negative.

What does all this mean for future Fed interest rate moves?

Folks expecting a quick pivot away from increases are going to be disappointed.

But any future rate hikes may be smaller and slower paced as the Fed takes stock of the data and works to keep us out of a recession (fingers crossed).

Federal Reserve chair Jerome Powell has admitted that inflation has begun to fall, but he wants to see “substantially more evidence” of a declining trend before changing policy.

With inflation still three times above the Fed’s 2% target, there is still a long way to go before we are out of the woods and back on the path. We predict inflation may fall to 4% by the end of the year but nowhere near 2%.

What could happen with markets?

We expect a lot of volatility ahead as markets digest every shred of information about the economy and the direction of interest rate policy. Earnings drive markets, and right now, the profits are not great. In fact, they are not even good. We see year-over-year declines in most S&P 500 stocks and Nasdaq stocks. So, for all the noise you hear about the Fed, interest rates, and inflation; it always comes back to how much money did the company make? This last quarter, they made less than they did in the quarter 12 months earlier.

I do not have a crystal ball here, but I think it will be a rocky spring. Typically, we have two types of markets: bull and bear markets. I am coining the kind of market we have been in since last June, and I think we will see for another few quarters a “mechanical bull” market. Like a mechanical bull that you can ride (yes, I have ridden one, and no, there are no pictures floating around), there will be a whole lot of bouncing around, and if you are lucky, you are still upright on the bull and not the ground in pain. The good news is that many of our portfolios have had speed controls placed on them for the last 7-9 months, so there has been and will be, a lot less bouncing around for you. Not saying it’s all smooth sailing, but you can imagine the difference between riding a mechanical bull at full speed or one at quarter speed; that is what we think we will see.

There will come a time when we can start adding back to equities like our “normal” positioning, but we are still not there yet.

We will continue to watch markets and look for opportunities.

We will be in touch as needed.

Best,

Michael