'Rocky landing' landing

As regular readers of my memos are aware, since early in the summer of 2022, we’ve been calling what the economy is going through—an asynchronous, bumpy and at times scary period of economic adjustment to the Fed’s higher interest-rate regime—a “Rocky Landing.” We thought then and think now that this period would hit some sectors harder than others and would last through 2022 and most of 2023. Importantly, we thought it would not result in a classical, economy-wide contraction, i.e., a recession. By early January of this year, with the rocky landing halfway over, we moved back to a modest overweight in equities, (“The other side of zero”) and have been legging more money into the market regularly since (“Please Sir, can we just get on with the ‘Big R’ Recession?” and “10 Reasons the market’s glass could be half full, not half empty”). Our cautiously constructive idea has been that while the economy was in the midst of a rocky landing off post-Covid highs and earnings forecasts were coming down, time was on the side of the optimists. 

With each day that has passed this year, the better days of 2024 have drawn more into focus. Inflation data has crept downward, the Fed has slowed the pace of its aggressive monetary tightening program and fear of a sudden, economy-wide recession has subsided. Now, earnings numbers are stabilizing. As nominal sales flow through corporate income statements whose cost structures have been adjusted for the recession that is not happening, we think by the numbers, earnings will inflect higher, not lower, by the October reporting season. This is the moment we’ve been waiting for.

Yesterday, we upgraded our full-year 2023 and 2024 earnings forecasts for the S&P 500 to $230 and $250, respectively. With that, we’ve moved our upside 2023 target from 4,400 to 5,000. For now, we are sticking with our 30% overweight position to equities, leaning heavily within that overweight toward large-cap value, small caps and international equities. 

In short, the “Rocky Landing” is finally landing.

Let’s unpack all of this.

• Inflation data getting better by the day. By every metric, price increases have slowed dramatically. Headline CPI rose at a 3% annualized rate in June, its slowest pace since March 2021 and less than a third of June 2022’s y/y increase of 9.1%, a peak for the current economic cycle and the highest annual rate since November 1981. Core prices have been stickier but are slowing, too, as both hourly earnings and rents pull off their peaks. PPI has been in a downward trend all year, with negative prints two of the past four months. Importantly, June’s m/m prints for core CPI and PPI imply that on a run-rate basis, inflation is now running very close to the Fed’s long-term target. We get a fresh reading this Friday on PCE, which in May increased just 0.1% m/m and 3.8% y/y, the lowest reading since April 2021. Globally, a struggling economy in Europe and a disappointing reopening in China, where the worry is deflation, have driven energy and agricultural prices well off their cycle highs. This disinflation in commodities and goods inputs gives corporations leeway in setting wage rates without sparking a margin decline and/or another inflationary impulse.
• The Fed is either done or close to it. Tomorrow’s quarter-point hike after June’s pause appears baked in, but after that, we’ll see. With inflation trending rapidly toward their 2% target and “long and variable lags” still working their way through the economy (remember, this tightening cycle only started 16 months ago), policymakers almost certainly see no reason to keep going full bore. Hawkish rhetoric is one thing but actions are what matters, and it’s hard to see Chair Powell and his team acting again until late fall if at all the rest of the year. Perhaps unappreciated, given his overdone devotion to zero-bound and misguided “transitory” mindset, was Powell’s vow to act aggressively once the Fed began to move. It did that, with the most rapid rate increases since the Volcker era. Now, time is on its side.
• The economy has failed to collapse. Far from it, actually. GDP growth surprised to the upside in the first quarter and may do so again with this Thursday’s initial read on Q2. Our macroeconomic policy committee this week raised its growth forecasts for this year and next, and frankly as only one voting member in the group, I think the numbers could still be low. The resilience of the labor market and the consumer against the most dramatic rate-hike cycle in two generations and struggles in Big Tech and some regional banks has been nothing short of remarkable. While job growth has slowed, it’s historically robust, with unemployment continuing to hover near all-time lows. Everywhere one travels, hotels, restaurants and other service establishments continue to complain about a lack of workers, not a surplus. Hard to see this changing on a dime. And while the so-called “excess savings” from Covid stimulus may be running out and a renewal of student loan payments looms, consumers are in a good place, working and earning fatter paychecks. Their balance sheets are healthy, too—household net worth-to-disposable income is near an all-time high, household debt-servicing costs are close to historical lows and real incomes are on the rise.
• Earnings are stabilizing. Not surprising, as CFOs around the country have been adjusting down their cost structures and inventories in anticipation of the recession that all the experts have assured them would occur. By Q3, higher nominal sales from an economy that is growing, not shrinking, should be flowing through lean corporate cost structures, leading to a sudden and unanticipated earnings inflection. This likely outcome drove our decision to lift earnings projections for this year and next, reversing somewhat our admittedly more bearish view at the end of last year. 
• A new Bull may be about to be born. As earnings inflect higher, the markets will be looking forward to 2024, likely to feature a continued slow decline in inflation data, a stable then probably loosening monetary policy, and policy stimulus in China. Once we break through the old highs, the bears, who’ve been assuming those highs represent the market’s natural ceiling, will be forced to capitulate. Importantly, the greatest operating leverage, should we be right, will be witnessed in the so called “Value” ends of the market—cyclicals, small caps, regional banks, international stocks and emerging markets. We think the “broadening out” of the rally that began this month is therefore likely to continue and explains our overweights to all these areas.

With the Rocky Landing in its final landing stages, we acknowledge there potentially will be a few further bumps along the way. Perhaps Chair Powell will deliver a particularly hawkish talk at next month’s Jackson Hole, Wyo., confab, trying to slow down the bull. One of the big tech darlings that have led the market this year could cough up a hairball later this week or next. Though not nearly as pervasive as during the 1970s’ stagflationary era, one of the union strikes currently underway or in the pipeline could produce an alarming wage settlement. Who knows? Even as a new Bull is born, the Wall of Worry is its fuel. With a mountain of cash still on the sidelines, we expect any and all dips to be bought from here. Welcome to the landing.