Capital Market Comment
May 15, 2023
Frank Mastrapasqua, Ph.D.
Navigating the Uncertainty
Earnings season is drawing to a close, and the results have been better than expected. With over 90% of the companies in the S&P 500 having reported, nearly 80% beat earnings estimates and 72% beat revenue expectations. On a year-to-year basis, the quarter is expected to show a 3-4% decline, compared to a 6-7% decline estimate. What is remarkable has been how many companies have been successful in navigating the economic uncertainties.
Since the most widely anticipated recession in history continues to be elusive in the aggregate, many companies have built in conservative forecasts. The current environment captures two key elements – inflation and growth. Pricing power (and margin preservation) were apparent in Q1 earnings.
Just maintaining existing prices, by definition, means no inflation. As recessionary conditions take hold in certain sectors of the economy (particularly in manufacturing), falling commodity prices impact input costs. Maintaining profitability in the aggregate can be attainable. Many companies have done just that. The Wall Street Journal reported that profit margins are estimated to have ticked up in Q1 following two down quarters. The companies that have successfully navigated the “downturn” are being rewarded and are likely to be leaders in the equity market in the coming months.
The weight of the Fed and the debt ceiling are near term constraints. The monetary authorities’ recent increase in the Fed Funds rate to 5%, the 10th increase, at the May meeting again points to overkill. The one consolation is that it appears to be the last one. The pause is here!
The Fed’s recent field survey of banks points out the tightening of credit availability—mortgages, home equity loans, credit cards, etc. is underway. Many estimate that the credit constraint is equivalent to a 50-basis point increase in short term rates.
Recently, some members of the FOMC have indicated a pause is in order, in part because the lagged effects are just being felt. Chicago Fed President Goolsbee has been the most outspoken. At the same time, the banking crisis is well underway. The crisis can be laid at the feet of bank management, federal regulations, and the Federal Reserve. It appears that the federal infrastructure of regulation and policy is in shambles. The end of the banking crisis seems elusive. Every pause seems to be followed by another episode—deposit outflows—that triggers another downdraft in the regional banks. Clearly, the ten rate increases and 500 basis point rise in short-term rates have placed many smaller banks in untenable positions. Their business model does not work. Net interest margins have collapsed and profitability for many institutions has disappeared. They are also exposed to the emerging commercial real estate downturn, a multi-year phenomenon.
This environment that the monetary authorities created will most likely be the catalyst for moving from an offensive strategy to a defensive one. 2023 is likely to be an important transition year, and a change in direction for short term rates and major banking reform. The Fed may well have to tolerate an inflation rate higher than 2%.
The economic data is providing a backdrop for policy change. The CPI and the PPI are in a decided downtrend, with the monthly annualized rate less than 3%. The CPI has shown the 10th month of declining inflation.
Employment growth has slowed in the last three months, due in part to downward revisions in February and March. Initial claims for unemployment insurance have been rising, an indication of a changing employment picture. Furthermore, the ISM survey for manufacturing points to contraction. Additionally, the consumer is providing little help. Consumer sentiment has fallen sharply. Real retail sales and income have been negative, and credit availability and interest costs are taking their toll.
Any meaningful break in employment will bring significant political pressure upon the monetary authorities to which they are likely to succumb. With their credibility in question, aided by their failed supervision, dissention appears to be growing within the Fed. Change is in the offing.
The equity market is wrestling with these concerns, as well as the debt limit crisis and the Ukraine conflict. Despite these uncertainties, stocks have performed reasonably well. The NASDAQ appears to be in a new “bull market” having risen more than 20% from its low, with the S&P 500 and the Dow holding above their fifty-day moving average.
Many pundits, in referring to the past, point to the lack of breadth and the narrow leadership as bearish indicators. From our perspective, every cycle is different, including this one. Once there is greater clarity on the debt ceiling and the economic cycle, the breadth is likely to return.
In this market setting, it appears prudent to focus upon sectors that have little exposure to the business cycle — AI, defense, pharma, biotech — and areas that appear to have already discounted recession — semiconductors, housing, etc. Sentiment, cash positions, and just plain disbelief have made stocks poised to respond to a “catalyst”— and respond they will!
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors. If you have a question or need further information, please contact:
Edwin Barton, Principal, Chief Portfolio Strategist in Nashville at 615-255-9898, firstname.lastname@example.org
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, email@example.com
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The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.