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What is the market pricing in?

| May 30, 2023

Before we get to the markets, please let us say we hope you had a wonderful Memorial Day. While it marks the unofficial start of summer, it certainly means much more – and our hearts go out to those who have lost a loved one in the military. We are grateful for their service and the sacrifice made by so many.

Turning our attention to the markets, the big issues they are contending with right now are the following.

  1. Inflation
  2. Recession
  3. Earnings
  4. Debt ceiling ‘crisis’
  5. Banking ‘crisis’

So, let’s tackle the easy ones first. We said last week that the debt ceiling would get raised either shortly before the deadline or shortly after. The Treasury can pull a few levers and, for the most part, things will get paid. It’s not a crisis the media makes it out to be, mostly because it has to get solved and will. That doesn’t preclude politicians getting screen time showing their constituents they are out there working for them. You can see below how many times the ceiling has been raised. You can also see how the debt has gotten out of control, now over 129% of GDP. The hard part is now the US government has to pay higher interest rates on what now totals $31.4 trillion. Even if we say 4% on that debt, it’s over $1.2 trillion in interest every year. As we have said before, it’s not so much the level of debt that is the concern. It’s the cost of servicing that debt, and that cost is going up! It will become a classic case of either crowding out other spending or leading to more debt – outcomes that aren’t preferred by either side of the aisle, respectively.

Next is the banking ‘crisis.’ Again, this is a crisis in that the media has made it a crisis. And yes, if you had more than $250,000 in SVB and the FED and Treasury didn’t protect your excess cash, it would be catastrophic. So, the FED creates a potential problem by raising rates the fastest and highest EVER (see below). Then it comes in and ‘fixes’ the problem by backstopping all deposits, which in turn creates a potential moral hazard down the road.


Inflation rates have been coming down and will continue to come down. Except there’s a problem with the math… I know, not math again!

In the chart below, you can see that May and June last year showed huge inflationary spikes. Those months will be falling off over the next month or so, as the current May 2024 and June 2024 inflation numbers are released. Now of course, we are just finishing up with May, so we won’t see that number until the middle of June and the June number in the middle of July. But you can expect that of the 2.1% inflation for those 2 months, likely around 1% will come off, leaving us with a 12-month inflation rate of somewhere around 3.8% to 4.1%. Down substantially from the highs around 9%. And down from the 4.9% rate as of April.


So, inflation is coming down, but the FED’s target is 2% and we are roughly double that in a couple months (after 2 big inflation prints are removed). Throw on top of that, August 2022 inflation for the month was ZERO, so unless we replace that with a ZERO inflation this August, we will see a slight uptick in the inflation rate in August. Keep in mind that we have been arguing the 2% FED target is completely arbitrary and the long-term average of inflation is in the 3.25% range.

The concern is the FED’s obsession with 2%, when they could reset their “allowable” inflation to the long-term average, and we are basically there. That would do a lot for the economy and earnings of companies and be a very bullish turn for the markets and our view of the potential of a policy error.

Next is recession…will we or won’t we? Will it be deep or shallow? We have said that, barring a policy error from the FED, we would expect the economy to hold up pretty well and if we had a recession it would be very mild. We also said that if it was a mild recession, that the lows of the markets have likely been put in around 3500-3600 on the S&P 500.

Maybe I’m too cynical of the FED but making a bet that they will achieve a “soft landing” is a bit much for me, especially since they have not shown the ability to do that in the past.

Here is the FED’s own recession model from the New York Federal Reserve. You can see they are forecasting a 68% chance of a recession within the next 12 months. You can see that any time their model has been this high we have already entered into a recession, or it was soon to follow. This is no different than other models we have shown before.


Finally, we showed you last week how the earnings revisions are starting to turn up. That is a very good thing. We also had Nvidia come out last week with earnings and they were EXTREMELY bullish on the future of AI chips and AI in general. To be clear, some industries will be negatively affected by AI, while others, like semiconductors, will likely see massive new markets and revenues. Is that enough to power a huge earnings recovery? My guess is the market is a bit ahead of itself, but yes, eventually it will be huge (in ways we can’t even think about today). In fact, one of those companies that may be a beneficiary of AI is Monolithic Power Systems (not a recommendation to buy or sell), based right here in Kirkland, Washington.

Again, IF (a big IF) the FED doesn’t push too hard on the economic brakes, we should likely see earnings rise in this next cycle, due to both performance and inflation. Odds are now saying there will be another quarter point increase in rates (0.25%) on June 14th, bringing the FED funds rates to 5.25%-5.50%. Then there’s the matter of the market anticipating the FED cutting rates sooner than the FED has said they would. Of course, how do you assume rate cuts while they are still in rate hike mode? One of life’s mysteries, I guess.

I hope you had a great Memorial Day weekend. If something doesn’t make sense or you want clarification, let’s talk.