What I Care About This Week | 2023 Jan 16

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Photo by Sebastian Arie Voortman on Pexels.com

by Franklin J. Parker, CFA

The Summary

  • Earnings season has begun, and this quarter’s reports are very important for the outlook of the economy and markets. As it stands, S&P 500 companies are expected to report making 2% to 4% less money than they did at this time last year. This would be the first quarterly contraction in earnings since the Covid-induced recession in 2020. Several major banks reported earnings on Friday and despite delivering strong results that beat expectations, banks have set aside considerable funds to offset loan losses in the coming year. JPMorgan, for example, set aside $1.4 billion in this quarter — no small sum.

  • Last week’s big news was inflation which posted exactly in-line with expectations: 6.5%, year over year. In response, investors adjusted their expectations for the Fed, now anticipating a 0.25% rate hike from the February 1 announcement. I am not so sure that is the right move, since the Fed has repeatedly warned that they will continue being aggressive until inflation is under control. Again, according the Fed’s own data, that means pushing the economy into a recession. I do not expect them to back away from that plan.

  • The Bottom Line. I see a recession forming this year, and investors may do well to use recent rallies to lighten their risk load. While it is certainly possible that markets rally from here (especially if the Fed delivers a 0.25% rate hike), the deeper economic data indicates a slowing economy. Coupled with a potential earnings contraction in this quarter and the next, and it is easy to see how prevailing risk is to the downside.

The Details

Well, the debt ceiling is back in the news. Why does it matter to investors?

The debt ceiling is a check on the power of the US Treasury. In a nutshell, congress authorizes spending but gives the US Treasury lots of leeway over how to fund that spending. Obviously, ongoing tax receipts are a major source, but because the government spends more than it receives in revenue the US Treasury must issue debt to cover the shortfall. Congress says that’s okay, but only up to a point. That is the debt ceiling.

Investors view US government debt as among the safest debt in the world. This means that lots of cash is tied up in US government debt — and that is typically cash that cannot afford to be lost. Furthermore, because investors see little to no chance of default in US government debt, it is the benchmark by which all other debts in the economy are priced. That is, if I can lend my money to the United States at 4.5% and get paid back for sure, I will need to earn more than 4.5% on my money to lend it to my uncle Jack since I have much less of a chance of getting paid back.

For the US government to default on her debt obligations, not only do lenders to the government lose money they cannot afford to lose, but the fundamental benchmark of the economy is undermined. Investors would have a strong sense of vertigo while scrambling to find a new benchmark from which to price home mortgages, car notes, credit card rates, and other bond rates.

In short, the US government outright defaulting on her debt is an economic catastrophe. Which is why investors care so much about the chances of that happening.

Chart of the Week

Many financial analysts and news organizations have dedicated an inordinate amount of time to the question of what the Fed’s next move might be. There is good reason for this, as the chart below demonstrates. The S&P 500 has followed the Fed for the past year — as rate expectations have risen (black line, and lower means higher rate expectations), markets have fallen. Even divergences (like March-April of 2022) get reversed pretty violently.

Since October, the market has begun to rally away from the Fed, and partly because expectations have begun to level off. However, poor economic data is beginning to take over, and that may yet push markets lower.

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