Aftershocks part 4: 1Q2023 EPS season will show whether economy or inflation broke. Fed running out of reasons to hike rates in 2023 given JOLTS/PCE/ISM/Dallas Survey.

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Based on my recent meetings, it is obvious institutional investors are waiting to see what broke with SVB/Fed hikes — is it the economy or inflation? Naturally, one is generally bad (economy) and the other is generally good (inflation).

• Investors believe “economy broke” post-SVB, not inflation: The vast majority of our clients are cautious (no need to explain, its known), and their belief is the economy broke with a “hard landing” ahead. Inevitably, these discussions reach a question “Tom, when (or what catalyst) will you capitulate on your positive view on equities?”
• Arguably, the “make or break” of this bearish view will be upcoming 1Q2023 earnings season. EPS expectations have fallen for the past 6 months but have leveled off for 7 of 11 major sectors: Comm Services, Industrials, Materials, Healthcare, Staples and to an extent Technology and Utilities. They are only falling recently for Energy and Financials.
• Stocks have been resilient in the face of fundamental “bear catalysts” such as: (i) Fed hikes >500bp in 12 months; (ii) Oil surges to >$100 in 2022; (iii) Inflation surges to >10% in 2022; (iv) Regional bank crisis erupts in 24 hours. And yet, stocks have managed to gain 7% YTD and post gains in March, with FAANG >30% YTD and Technology >15%.
• So, it may be that 1Q2023 earnings season could act as the final “capitulation” of the bearish view. Banks start to report next week with JPMorgan JPM 0.20%  on 4/14. As we noted in our comments earlier this week, we believe bears are trapped as the S&P 500 has posted two consecutive quarterly gains. This has never happened in a bear market, at least since 1950. So, the burden is now on the bears to show this time is different.
• I did not realize this, but the “supercore” PCE Feb deflator (core services ex-housing), reported 3/31 last week, hit the Fed “target” — this figure was 3.3% (1M annualized) and lowest since July 2022. But the more important takeaway is this level is below the 4.0% 65-year average (since 1960) and just about at the 45-year average of 3.1% (since 1980).
• If the Fed is concerned about “core services inflation” and now this figure is at the 45-yr average and below the 60-yr average, does the Fed need to be thinking rates will be considerably higher from here? Why?
• We would argue that this plus yesterday’s JOLTS and yesterday’s Dallas Fed Bank Survey show the Fed has even fewer reasons to hike rates. The Fed doesn’t have to raise rates if there are clear signs:
  – jobs demand slowing measured by JOLTS (Powell cited) and tanked in Feb
  – ISM March employment fell to 46.9, the lowest since July 2020, so more signs
  – super core PCE slows (now below 40-yr avg)
  – demand slows materially and March Dallas Fed survey shows dramatic decline
• Feb JOLTS collapse in job openings at 9.93mm vs Street 10.5mm (10.82mm last month). Job openings/worker ratio is now 1.67 from cycle high 1.97 two months ago and the lowest ratio since Nov 2021. This is for Feb JOLTS and before the ripple effects of SVB/regional bank crisis are seen. That means we would expect even more declines for March (reported next month). That is a materially softened job market.
• Dallas Fed Bank Survey for March (period is post-SVB) shows a meaningful drop in loan volumes, particularly consumer. This is what Fed would want to see. Fortunately, there was a net improvement in loan quality, so it is more of a volumes versus quality deterioration. That is supportive of lower inflation. And credit contraction, as Powell noted, is the equivalent of Fed hikes.
• Monday, the ISM Manufacturing March survey headline figure came in soft 46.3 vs Street 47.5 (47.7 last month) and key subindices employment and prices paid both soft. Employment at 46.9 is lowest since July 2020. Prices paid slipped below 50 again to 49.2, affirming the trend in prices is lower.
• Collectively, to us, this suggests the drivers of inflation are even softer (JOLTS, credit creation, PCE). While some might be concerned the Banking Conditions survey and ISM are signs “economy broke,” keep in mind these have been weak for sometime. So these are simply only affirming those trends. Additionally, we believe consumer expectations of inflation has changed as well. That is, how many will be asking for a raise? Or tolerating prices increases?
• As for those saying equity gains are narrow and defensive, this is not true. As we highlight below, leadership has been: Tech/FAANG, Energy, some Industrials, Materials and Staples. The drags on S&P 500 performance have been Utilities, Financials, Telecoms and Healthcare. The drags have been largely Defensives.
• RISKS: Of course, there are risks. The economy absorbed a financial shock and ripples are continuing. And the bank crisis is still festering. And Oil surged earlier this week on a surprise production cut by OPEC. WTI oil surge to ~$80 Monday after falling to low $60s earlier in 2023. Do we think this is the start of another inflation cycle? Not really. This is still within the range of prices since 2022 (oil spent a lot of time around $80 last year) and this production cut price rise is different than the surge last year on the heels of Russia-Ukraine war. If anything, this supports why Energy is our #2 favorite sector in 2023.

BOTTOM LINE: Yesterday’s JOLTS and Dallas Fed bank survey support the idea that incoming data points to a softening of inflation but not as much the “economy broke.” Notably, loan quality net improved in March. The March employment report this Friday will be more evidence, but think softening of the labor market would be a welcome development.

EPS: 7 of 11 are seeing signs of bottoming estimates

This upcoming earnings season will be an important moment for those bearish, as this is arguably the last fundamental catalyst for the bear thesis:

• Arguably, the “make or break” of this bearish view will be upcoming 1Q2023 earnings season. EPS expectations have fallen for the past 6 months but have leveled of for 7 of 11 major sectors: Comm Services (XLC -0.44% ), Industrials (XLI -0.04% ), Materials (XLB -0.38% ), Healthcare (XLV -0.03% ), Staples (XLP -0.76% ) and to an extent Technology (XLK 1.08% ) and Utilities (XLU 0.02% ). They are only falling recently for Energy (XLE 1.15% ) and Financials (XLF 0.18% ).
• The SVB crisis certainly hurt credit creation and slowed labor markets, so we know there will be knock on effects. But the real question is how markets will react. JPMorgan is the first major bank to report and 1Q23 is set to be released on 4/14.
• But we know markets bottom on bad news. So if stocks rally sharply next week, we think this could be the moment of the bear capitulation.

Fed running out of reasons to hike…

As we noted above, we argue that this plus yesterday’s JOLTS and yesterday’s Dallas Bank Survey show the Fed has even fewer reasons to hike rates. The Fed doesn’t have to raise rates if there are clear signs:

• jobs demand slowing measured by JOLTS (Powell cited) and tanked in Feb
• ISM March employment fell to 46.9, the lowest since July 2020, so more signs
• Super core PCE slows (now below 40-yr avg)
• Demand slows materially and March Dallas Fed survey shows dramatic decline

Look at JOLTS below. The 2 month change in JOLTS is staggering, falling 1.3 million.

• this was only matched by the collapse during pandemic era
• This is for Feb, pre-SVB/regional banks. Imagine what this figure looks like next month?

And JOLTS is finally catching up to the other job opening surveys of LinkUp and Indeed.com

And the ratio of job openings/workers made a big improvement. At 1.67, it is the best ratio since Nov 2021. And gain, this is before SVB/regional bank crisis.

Dallas fed survey: Loan volumes down but quality up

I think this will be important for Fed. The Dallas Fed Bank Survey for March (period is post-SVB) shows a meaningful drop in loan volumes, particularly consumer. This is what Fed would want to see.

• “loan volumes fell, driven by a sharp contraction in consumer loans”
• This shows SVB/regional bank crisis is slowing credit creation. As Powell noted, this is equivalent of Fed hikes.
• Fortunately, there was a net improvement in loan quality, so it is more of a volumes versus quality deterioration. That is supportive of lower inflation.

Our team charted the diffusion of loan volumes versus loan quality — that net % better less % worse:

• this shows that loan volumes net declined sharply
• but loan quality improved
• this is actually a good combination
• inflation is slowing but credit slowing is not creating delinquencies

And finally, note the improvement in ISM employment and prices paid.

ECONOMIC CALENDAR: Key is inflation, but data reported in March leaned to “softer” inflation

The key data reported in March (Feb data) was overall dovish as it showed softer inflation.

Key incoming data starting March 19

• 3/7 10 am ET Powell testifies Senate Hawkish
• 3/8 10am ET Powell testifies House Neutral
• 3/8 10am ET JOLTS Job Openings (Jan) Semi-strong
• 3/8 2pm ET Fed releases Beige Book Soft
• 3/10 8:30am ET Feb employment report Soft
• 3/13 Feb NY Fed survey inflation exp. Soft
• 3/14 6am ET NFIB Feb small biz survey Soft

• 3/14 8:30am ET CPI Feb Tame
• 3/15 8:30am ET PPI Feb Tame
• 3/17 10am ET U. Mich. March prelim 1-yr inflation BIG DROP
• 3/22 2pm ET March FOMC rate decision DOVISH
• 3/31 8:30am ET Core PCE deflator Feb Tame
• 3/31 10am ET U Mich. March final 1-yr inflation Tame

And the key data to watch in April is below.

Key incoming data April

• 4/3 10am ISM Manufacturing Employment/Prices Paid March Tame
• 4/4 10am ET JOLTS Job Openings (Feb) Tame
• 4/7 8:30am ET March employment report
• 4/12 2pm ET March FOMC Minutes
• 4/12 8:30am ET CPI March
• 4/13 8:30am ET PPI March
• 4/14 7am ET 1Q 2023 Earnings Season Begins
• 4/14 Atlanta Fed Wage Tracker March
• 4/14 10am ET U. Mich. March prelim 1-yr inflation
• 4/19 2:30pm ET Fed releases Beige Book
• 4/28 8:30am ET PCE March

STRATEGY: Cyclicals outperforming more than Defensives

We have highlighted the 2-yr relative performance of the major groups below and as shown, the leadership is more cyclical.

• Leading are Tech/FAANG, Energy, some Industrials, Materials and Staples.
• The drags on S&P 500 performance have been Utilities, Financials, Telecoms and Healthcare.
• In other words, the drags have been largely Defensives.
• This is counter to those saying this rally in 2023 is Defensive stocks.

And our base case for April remains a strong >4% rally, following the pattern of “Rule of 1st 5 days.” The Rule of 1st 5 days looks at years when S&P 500 gains >1.4% in 1st 5 days and is negative the prior year.

• This has happened 7 times since 1950: 1958, 1963, 1967, 1975, 2003, 2012 and 2019.
• Based upon those 7 years, April implied gain is +4.2% and was positive 6 of 7 times (only 2012, -0.7%). This implies +175 points, or S&P 500 >4,275 by the end of April.

A gain of 4%, or +172 points would put S&P 500 >4,250 by the end of the month. And we think this would ultimately force a bear capitulation.

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