Is the current rally premature?
Montgomery Investment Management
I believe there are good arguments the current rally is premature and might reverse. Keep in mind I am still long and heavily invested in equities. I just think the current rally has got ahead of itself.
First, S&P500 forward earnings estimates are declining. Not by much but definitely in the wrong direction. Back in July the S&P500 was expected to earn $250.70 per share in 2023. Today that number is $243.81. As I say it's only a 2.7 per cent decline but it is a negative.
Secondly, while many indicators suggest headline inflation has peaked, it's the core inflation number that matters and that is driven primarily by service inflation, which in turn, is driven by wages.
The Federal Reserve Bank of New York's Global Supply Chain Pressure index has rolled over, as has U.S. ISM Manufacturing Supplier Deliveries Index and the ISM Manufacturers Backlog of Orders Index. Prices for dynamic random access memory and shipping (as measured by the Baltic Dry Shipping Index) are also falling, as is the price of oil.
These declines indicate pressure on the supply chain is easing which in turn gives goods supply a chance to catch up to demand. Moving towards equilibrium should ease goods inflation.
Equity markets have understandably become excited. With inflation peaking, the current wave of central bank interest rate rises might lead to rate cuts next year, especially if the current wave of rises causes a recession.
One element of inflation however not considered in the above narrative is the extent to which Core inflation is impacted by services. Services generally make up about 73 per cent of Core CPI. 'Services' is responsible for four per cent of the six per cent Core CPI reading in July. And the biggest cost to services businesses are wages. Wage inflation meanwhile is high. Indeed, in the U.S., private sector wages and salaries have jumped 5.7 per cent, even though the U.S. economy is slowing down. To put this in perspective private sector salaries rose by two per cent in the first quarter of 2016 and by about 1.75 per cent in the first quarter of 2012.
Meanwhile, the employment cost index, a figure U.S. Fed policymakers follow closely, rose 1.3 per cent in the second quarter. This index climbed 5.1 per cent over 12 months, which is a record for the data series that commenced in 2002.
And the U.S .Federal Reserve's preferred inflation measure, the Personal Consumption Expenditure price index set a new 40 year high in June.
All that tells me is that inflation could prove to be more persistent than the market currently hopes. Of course, if inflation is truly 'old' news and on its way down, then it is possible the lows for the bear market have already been seen. If, on the other hand, the market's current optimism about an end to rate hikes this year and the beginning of rate cuts next year proves unfounded, or even premature, then the current rally is also premature, and investors may yet see another reversal in prices.
Finally, keep an eye on global liquidity. Liquidity matters far more than interest rates when debts need refinancing. Currently, the pace of balance sheet unwinding has slowed. The U.S. Fed paused its liquidity squeeze in July, providing a fillip to equity markets. But all major world central banks are in tightening mode, as are 90 per cent of emerging market central banks. Large balance sheet declines are equivalent to material increases in interest rates. According to some analysts, if the U.S. Fed hits its US$6.5 trillion balance sheet target, it will be equivalent to an effective U.S. Fed Funds rate of nearly eight per cent.
If the Fed resumes its stated 30-month QT program, further declines in liquidity can be expected.
As a net buyer of stocks, we look forward to the opportunity to add to investors' portfolios at cheaper prices. And being near fully invested now, we also look forward to higher prices.
Author: Roger Montgomery, Chairman and Chief Investment Officer
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