What I Care About This Week | 2023 Feb 13

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Photo by Follow Alice on Pexels.com

by Franklin J. Parker, CFA

The Summary

  • This week we see more earnings, with AIG, Coca-Cola, Cisco, Deere (and several others), all reporting. In general, this has been a disappointing earnings season. With about 60% of S&P 500 companies having reported, it appears that, on average, companies have seen about 5% less profit than last year at this time. Of course, that is not evenly distributed across sectors, as our Chart of the Week demonstrates.

  • Tomorrow we get the all-important inflation figure. At the moment, analysts expect prices to have increased about 5.5% over last year, which is certainly down from the peak but still much higher than the Fed’s 2% inflation target. A figure higher than 5.5% would easily move markets lower, while a figure less than 5.5% could move markets higher. We also see retail sales, industrial production (which is on my recession dashboard), producer prices, and housing starts. All of these are important pieces of the economic picture.

  • The market’s recent rally off of its October bottom has been rather dramatic, and it does fuel a fear of missing out (often dubbed FOMO in financial news). As I read the data today, however, it appears to be driven by hopes of continued economic growth and a general shrugging-off of the very real recessionary dangers that lurk in this economy. This rally, therefore, has given investors the opportunity to lighten their risk load, though, as usual, the specifics of your goals will determine what risks are acceptable for you.

The Details

Everyone is talking about the Fed (including me). What’s the big deal?

The Federal Reserve was established by Congress in 1913 in order to centralize control of the nation’s monetary system — banks, currency, interest rates, etc. Congress outsourced the management of monetary policy to the Fed with a mandate to maximize employment and price stability (often called the dual mandate).

In order to accomplish those objectives, the Federal Reserve has a few knobs it can turn.

First, and most famously, the Fed can adjust the amount of interest it pays banks for cash on deposit. Since the Fed is the safest investment a bank can make, anyone who wishes to borrow money must compete with the Fed’s rate of interest. Uncle Joe, then, will have to pay a higher rate than the Fed if he wants to borrow money to buy a car (because Uncle Joe is considerably less reliable than the Fed).

Second, the Federal Reserve can create and destroy US dollars. The mechanisms involved here are not straightforward, but, essentially, they print money and use the US Treasury and financial markets to put those dollars into circulation. They can also remove dollars from circulation.

Finally, and considerably less well-known, the Federal Reserve, through its oversight and regulation of the banking system, can adjust the amount of credit on offer in the economy.

Each of these “knobs” can be dialed up and down in order to achieve their mandate of low inflation (a.k.a. price stability) and full employment. However, full employment and price stability are traditionally seen as competing with one another: in order to lower inflation, the Fed must lower employment, and vice versa.

In the end, these tools have effects on both the real economy and financial markets — and those effects are not always aligned. Creating dollars and lowering interest rates has kept employment high, but also pushed asset prices higher, overwhelmingly benefitting the wealthiest. When attempting to deal with inflation, the Fed pulls back those dollars and increases interest rates, sending asset prices lower, but also tending to increase unemployment.

With so much power over both the economy and financial markets, the Fed has become the central player in market analysis and forecasting. So, regrettably, we have to discuss the Fed much more than usual these days.

Chart of the Week

This week’s chart comes to us from FactSet and shows the earnings growth of S&P 500 sectors relative to what their expectations were at the end of Q4 2022. Energy has performed the best while Materials and Communications Services performed the worst (which was expected at the end of last year). Ultimately, it appears that large US companies will report a decline in earnings of about 5% over this time last year.

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