Potentially "hot" April CPI report, testing height Fed pause bar...but so far 2023 is a "game of inches" where bulls gaining. Even global GDP creeping higher.

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Market direction in 2023 feels like a “game of inches” (Al Pacino in Every Given Sunday, see YouTube below). After last Friday’s surge post-April payrolls, the equity market has leaked lower over the beginning of the week (flat really). Overall, the bulls have the upper hand as the S&P 500 is up 8%. So while consensus views the macro picture with considerable uncertainty, equity markets have proven to be far more resilient. This is all ahead of the critical (market moving) April CPI, which will be released today (5/10) at 8:30am ET.

• The safer call is expect April CPI to be slightly “hotter” than Street consensus of +0.3% and April core CPI MoM closer to the Cleveland Fed InflationNOW forecast of +0.45% (trend model). Our basis is the stubborn increase in expected inflation from U Mich inflation survey (+100bp for month). Forecasting CPI is incredibly challenging, so take our comments with a grain of salt and it seems like the “whisper” from our clients is similar.
• Will a “hotter” April CPI compel Fed to hike in June? Fed futures implies a 12.4% of a June hike, so despite what is a “whispered” hot April CPI, rate expectations are muted. We think the bar has been raised for a June hike, given the combo of: (i) spreading regional bank stress; (ii) known contagion on the (unlikely) default of US debt; (iii) visible progress on slowing inflation and labor markets and (iv) known lags of monetary policy. This seemed to be the message from the May FOMC meeting last week and the key being the risks for regional banks if financial conditions remain too tight.
• A “hot” CPI will also further muddle the battle between those cautious/skeptical on the macro (hard landing ahead) vs those constructive (soft landing) and persuaded by the resilience of markets over the past 7 months. The leadership of FAANG remains impressive with the NYSE FANG+ Index up over 41% YTD. This is where the “game of inches” speech seems appropriate. Unlike prior years, there is no real middle ground.
  – if “hard landing,” equities have downside
  – if “soft landing,” S&P 500 surges (cash, shorts, 1982 analog)
• Hard-landing-ista point to “classic signs” such as (i) inverted 10Y less 2Y yield and (ii) ISM falling below 50 for over 6 months. Arguably, the inverted yield curve is due to inflation in “backwardation” meaning inflation next 2 years greater than next 10 years, so the yields need to reflect this. The current spread is -57bp. If inflation is 5% now, does one really think inflation will only be 50-60bp lower in a decade? See the point?
• Since 1945, the ISM Manufacturing has fallen to 48 or lower 25 times. Of these, a recession within 24 months has happened 11 times. So, the ISM at 47 is a good recession signal 44% of the time — it has called 25 of the last 11 recessions. ISM fell below 48 in Nov 2012, Jan 2016 and crashed April 2003. None of those were followed by or during a recession. The resilience of economies is not strictly USA. Global GDP estimates are moving higher as flagged by @MikeZaccardi citing research by Goldman Sachs.
• 5 reasons rate “cuts” priced into Fed futures July-beyond? Our clients still have a hard time reconciling the apparent contradiction of Fed futures seeing rate cuts in June (recession) vs stocks relative resilience. We think there are 5 possible outcomes:
  3 BAD (stocks to fall)
  – “Hard landing” ahead (then Fed cuts) (bonds right)
  – “Inflation too high” so Fed resumes hikes (bonds wrong)
  – “Financial crisis” so Fed makes emergency cuts (bonds right)
  2 GOOD (stocks to rise)
  – “Inflation falls sharply” so Fed relents (pauses)
  – “Give up on 2%” Fed tolerates inflation above target
• The political outcry and the distress from regional banks, in our view, incrementally argues for the Fed to “tolerate” inflation for some time. And this also means, tolerate easing financial conditions. We are also in the camp that inflation will cool faster than expected.
• The April PPI will be telling, released Thurs 5/11. March PPI was 3.22% YoY and April finished goods PPI is forecast to come in below this at 3.1%. The 75-year average is 3.15%, so PPI is already on “target.” Why would PPI be on target but CPI above target? There is a lag, so this should narrow (towards PPI). And “margin expansion” is the other. After all, this is a proxy for sales vs costs.

STRATEGY: A “hot” April CPI will add to market fears, but we remain constructive in YE 2023

The slow leak since Friday could become a bit leakier, but as we noted multiple times recently, we are more constructive on fundamentals and positioning is so cautious, that this is supportive of stocks (downside support).

• 1Q23 EPS season is largely finished and tracking for YoY decline of ~1%. Healthcare had worst YoY at -15% and ex-Healthcare, EPS would have been up +1%. S&P 500 2023 EPS estimates have increased since April 24th from $218.31 to $219.77. This is the first sustained gain since April 2022. So something is better.
• FAANG: We continue to favor FAANG/Large-cap Tech and that is our top sector pick. As we highlight below, the YTD gains of FAANG compensate for the terrible performance seen in 4Q22, mean reversion.
• Regional banks “Fed put”: Regional banks are down -37% YTD and this had been a “no touch” group. But if the Fed has a temporary put (pause on rates), we see the potential for a tactical rally. Consider the KBW Regional Bank Index KRE0.31%  has 52.5 million of its 79.5 million shares short. That is 66% of the shares sold short. 5 stocks with better metrics are NYCB1.71%  EWBC0.29%  WAL BANC-0.07%  CNOB0.50%  based on “tireless Ken” quant screens.
• Industrials: The bottoming of PMIs strengthens the case to be overweight Industrials. XLI-0.52% . As shown below, whenever PMIs fall below 50 and start rising (today), Industrials gain 95% of the time with a median 12 month gain of 22%. This is since 1948.

The macro remains challenging, so tread carefully. But we see positive risk/reward.

S&P 500: Slow leak since Friday

Equities have slowly leaked since Friday, but the crucial economic data comes Today (5/10) with CPI and Thu (5/11) with PPI.

The key will be CPI and PPI as we said. But we get wage data as well with average hourly earnings. Again, we believe it is safer to expect a “hot print”

The April PPI will be telling, released 5/11 Thu. March PPI was 3.22% YoY and April finished goods PPI is forecast to come in below this at 3.1%.

The 75-year average is 3.15%, so PPI is already on “target.” Why would PPI be on target but CPI above target? There is a lag, so this should narrow (towards PPI). And “margin expansion” is the other. After all, this is a proxy for sales vs costs.

• if the divergence holds up, profits to better
• or it could lend credence to those citing “corporate greed” to an extent. We don’t necessarily subscribe to that view.

The resilience of economies is not strictly USA. Global GDP estimates are moving higher as flagged by @MikeZaccardi citing research by Goldman Sachs.

FAANG: Still leading YTD

YTD gains show that risk-on sectors are leading. This is the frustrating divergence for those who see clouded macro risks. We agree macro risks are substantial, but a lot was priced by the 27% decline in stocks in 2022.

• since October, equities have consistently risen for 7 months now.

MACRO: Fed funds futures sees only 12% chance of hikes in June… bar is higher for a hike now?

Fed futures are showing a confusing picture:

• hike in June odds of 12%
• cuts thereafter.

We think the bar has been raised for a June hike, given the combo of:

• (i) spreading regional bank stress;
• (ii) known contagion on the (unlikely) default of US debt;
• (iii) visible progress on slowing inflation and labor markets and
• (iv) known lags of monetary policy.
• This seemed to be the message from the May FOMC meeting last week and the key being the risks for regional banks if financial conditions remain too tight.

But cuts thereafter are puzzling. One explanation is that this is a single figure, but there are probabilities of wider outcomes. If the Fed has to make emergency cuts, how does that get priced into these futures contracts.

RECESSION SIGNAL:

Hard-landing-ista point to “classic signs” such as (i) inverted 10Y less 2Y yield and (ii) ISM falling below 50 for over 6 months.

• Arguably, the inverted yield curve is due to inflation in “backwardation” meaning inflation next 2 years greater than next 10 years, so the yields need to reflect this. The current spread is -57bp. If inflation is 5% now, does one really think inflation will only be 50-60bp lower in a decade? See the point?

ISM is at 47 but likely turning higher. The S&P Global US PMI composite has been rising for 5 months, so the ISM is likely following suit. Many view ISM below 48 as recessionary:

• but since 1945, the ISM Manufacturing has fallen to 48 or lower 25 times.
• Of these, a recession within 24 months has happened 11 times. So, the ISM at 47 is a good recession signal 44% of the time — it has called 25 of the last 11 recessions.
• ISM fell below 48 in Nov 2012, Jan 2016 and crashed April 2003. None of those were followed by or during a recession.

1Q23 EPS: Way better than feared

1Q23 EPS season is largely finished and tracking for YoY decline of ~1%.

• S&P 500 2023 EPS estimates have increased since April 24th from $218.31 to $219.77. This is the first sustained gain since April 2022. So something is better.

• Healthcare had worst YoY at -15% and
• ex-Healthcare, EPS would have been up +1%.

ECONOMIC CALENDAR: Key May data is inflation and ISM, and April was overall “tame”

Key incoming data May

• 5/1 10am ET April ISM Manufacturing (PMIs turn up)Positive inflection
• 5/2 10am ET Mar JOLTSSofter than consensus
• 5/3 10am ET April ISM ServicesTame
• 5/3 2pm Fed May FOMC rates decisionDovish
• 5/5 8:30am ET April Jobs reportTame
• 5/5 Manheim Used Vehicle Value Index AprilTame
• 5/8 2pm ET April 2023 Senior Loan Officer Opinion Survey
• 5/10 8:30am ET April CPI
• 5/11 8:30am ET April PPI
• 5/12 10am ET U. Mich. April prelim 1-yr inflation
• 5/12 Atlanta Fed Wage Tracker April
• 5/24 2pm ET May FOMC minutes
• 5/26 8:30am ET PCE April
• 5/26 10am ET U. Mich. April final 1-yr inflation
• 5/30 Conference Board Consumer Confidence

Key data April

• 4/3 10am ISM Manufacturing Employment/Prices Paid MarchTame
• 4/4 10am ET JOLTS Job Openings (Feb)Tame
• 4/7 8:30am ET March employment reportTame
• 4/12 8:30am ET CPI MarchTame
• 4/12 2pm ET March FOMC MinutesTame
• 4/13 8:30am ET PPI March Tame
• 4/14 7am ET 1Q 2023 Earnings Season Begins Better than feared
• 4/14 Atlanta Fed Wage Tracker MarchSemi-strong
• 4/14 10am ET U. Mich. March prelim 1-yr inflationHawkish
• 4/19 2:30pm ET Fed releases Beige BookTame
• 4/28 8:30am 1Q23 Employment Cost IndexSemi-strong
• 4/28 8:30am ET PCE MarchTame
• 4/28 10am ET UMich April final 1-yr inflationHawkish

STRATEGY: Focus on Industrials, a week to make a tactical positive bet

Both the ISM PMI and S&P Global US PMIs are released on Monday:

ISM Manufacturing PMI has been better than consensus.

• Actual 47.1 vs Street 46.8 and last month 46.3

S&P Global US PMIs has come in slightly lower than consensus, but remains above 50.

• Actual 50.2 vs Street 50.4 and last month 50.4

Whenever PMIs bottom (see below), Industrials tend to bottom. This first chart shows rolling change for US PMIs and US Industrials returns.

This distribution table puts this in a clearer light. When PMIs are rising and from low levels, Industrials see strong gains.

• Since 1948, when PMIs are over 50 and are rising (n=60), Industrials see positive forward 6M and 12M gains of 85%/95% of the time with median gains of +12.6%/21.5%, respectively.

• Those are very favorable risk/reward and high absolute return opportunities.

Industrials are oversold vs S&P 500 on 20D %-change, with a z-score of -1.2.

• The top chart is the relative price ratio of Industrials vs S&P 500
• The bottom is the z-score of the 20D % change.
• The most recent 4 times this was seen, Industrials staged strong rallies vs the broader market.

• This is not that different than the signal we highlighted two weeks ago regarding FAANG/Technology. And we know that FAANG powered higher in the past two weeks

And Industrials are the most oversold vs other sectors, particularly against Staples.

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