Amid Hot Inflation, Markets Holding Steady

Good Evening:

Our research heads engaged in a lively discussion Thursday morning in New York. Here are the highlights:

Tom Lee, Head of Research: The Fed has an optics problem

The other day, Lee noticed something when shopping at the grocery store: prices were lower, and some items were on sale. It underscores his belief that beneath the 41-year-high inflation number, prices are coming down. Food prices are falling, gasoline prices are falling, airfares are falling, commodities are falling, home prices are rolling over and real wages are falling too.

“Markets are still under pressure,” Lee said. “There hasn’t been a good break in the inflation data. The CPI this week was a tough number for the Fed because they just have a huge optics problem. Headline CPI is 9%. We’re in a tough spot. The good news is I think it will lead to a break. … July will be first month we start to see lower gasoline show up in the CPI. Things in core inflation are still being affected by supply chains. But the leading indicators are saying inflation is rolling over. The public just doesn’t see it because the headline CPI number is huge and there’s still an optics problem for the Fed. That puts a lot of weight on the next couple of CPI reports.”

Lee’s question, then, is: “Are inflation expectations going to improve or worsen?” He believes the former, which would remove one of the biggest uncertainties in the market. “Markets are very scared of inflation,” Lee said. “It might take time to show up in the hard data, but I think inflation as far as we’re experiencing it has probably peaked. People think inflation is out of control, and the data shows that’s not the case.”

Then John Bai, our co-founder, asked Lee whether the Fed will lose credibility, meaning its actions and commentary would have less impact on the market. Lee paused.

“That’s the big intangible question,” he said. “The reason it matters is that the Fed’s communication strategy is probably their central policy tool. They have a forward path and guidance. That’s what sways markets. I think they didn’t [?] seem as far behind until yesterday and that’s why the two-year was pre-anchored and then the two-year popped yesterday. It shows the market’s nervousness about inflation picked up. The Fed then must contain it. The one thing to watch if you think the Fed has lost control is the spread between the Fed funds rate and the two-year. If that’s widening, it shows you the market doesn’t think the Fed is ahead of the curve.”

Brian Rauscher, Head of Global Portfolio Strategy: Worsening Earnings

Rauscher’s work has diverged from that of Lee over the last few months, and his view is no different as we enter earnings season. Whereas Lee remains constructive, Rauscher sees much more downside ahead because of negative earnings revisions. He noted that Q2 results from JPMorgan Chase and Morgan Stanley on Thursday did not set a good tone for earnings season, though Citigroup stock soared as it beat estimates and benefited from a rising rate environment.

“To me, this is about earnings,” he said. “The “E” is coming down. The markets are reacting to the “E” coming down. I like to over-simplify when I can. Inflation will peak at some point. I agree with Tom. Nothing in the components is accelerating, so inflation will peak. The question is: How quickly will it roll down, and how will that impact the Fed? There’s a view in the market that as soon as inflation peaks, the Fed will go from tightening to easing, and I don’t think that will happen.”

Rauscher said we likely will be discussing the Fed and inflation for months. Meanwhile, the economy will continue to slow down, and earnings will come down. He said we are still “a fairly long ways away” from getting to max pessimism on estimate cuts. Since 1990, Rauscher said, the market has never made a sustainable bottom before estimate revisions have reached max pessimism. He maintains his target of 3600-3500, with a high probability that we move lower.

“Don’t be surprised if I put up a 3000, 3200 in the near future,” he said. “The only thing that derails this is the sudden supply chain change for crude. The only way I see that is if Putin doesn’t wake up one morning.”

Rauscher added: “We will set ourselves up for a rally off 3000-3200 for a 30% year-end rally that puts us right back to 4000. And then we spend the whole first quarter, maybe the whole first half of next year, figuring out what’s going on with everything: the Fed, the economy, inflation. We have a big down coming and then we have a big up coming. And then tread water for a while. It will be hard for me to change my view unless something big happens, mainly because the earnings are coming down and most of my stuff is earnings based.”

Mark Newton, Head of Technical Strategy: The Bottom Is Almost Here

Newton, who in January correctly predicted the first half bear market of 20%, said his work is showing that markets are in better shape than they were in May, when the S&P was around 3800. This is closer in line to Lee’s view and differs from Rauscher’s bearish outlook.

Newton noted that we have been rangebound for several weeks, even if it doesn’t appear that way. His next target is near 3500-3600, which would be a 5% move lower. He believes that likely will be THE market bottom, on or around July 26.

“I think that will be achieved in the next week and a half to two weeks,” Newton said. “A lot of my indicators do suggest we are closer to a low in the market potentially for the year. It should happen in July. That’s based on my toolkit, which is cycles and momentum, which is getting less negative. And sentiment. Sentiment has been very bearish recently.”

Newton isn’t ruling out a Bitcoin breakdown into the low teens, which would be an excellent buying opportunity for longer-term investors. He also said it’s right to be in defensive sectors, with an eye on Technology, a sector that is holding up relatively well. See Apple, which is up 10% over the last month and down only 18% YTD. More broadly, Newton agrees with Lee. The headline inflation number is making the rounds, but it’s worth digging deep to understand what’s really happening: falling prices.

“Crude has had a huge drop,” Newton said. “None of this is taken into consideration among the media saying CPI is at 9%. All this stuff is falling dramatically. It will eventually matter. The Fed is in a tough spot. They must tackle inflation along with slowing growth. At least the inflation part is getting taken care of.”

Adam Gould, Head of Quantitative Strategy: More Downside Ahead

Gould said Idiosyncratic risk is down, and we could see a short-term bounce higher from here because the Reddit-based retail tracker he built turned negative again this week. But Gould doesn’t think any short-term move higher right now would be fundamentally driven.

“I still think the risk is to the downside, especially if earnings are going to be biased to the downside,” Gould said. “Long term, I don’t think up is the move. Maybe in 6-12 months. Short-term readings: no. I’m still very negative on discretionary, too… We’ve seen over two months that stock picking has become less important.”

Wishing you and your family a restful weekend of health and happiness,

-FSInsight Team