New York - October 9, 2023 ~ The team at Infrastructure Capital Advisors has completed our new report providing key insights on current market conditions and economic outlook for this month and the coming months. See this month's full report below but be sure to JOIN our Monthly Market & Economic Outlook Webinar scheduled for Thursday, October 12th at 1:30 pm ET where Jay Hatfield, CEO/CIO and portfolio manager will provide even more recent updates and insights to this report and the changing market and economy. Not registered for the webinar already? Click here to register. Also, by registering, we will send you a webinar playback video link if you are unable to join live.
Due to key influencers in the market and economy changing, the October Market & Economic Outlook report continues with some changes new from September with a specific focus on the Fed and ECB Outlook and the Inflation Outlook. Click any key area below to skip straight down to that section in the report.
Bond Market Outlook:
The most recent Eurozone now-cast indicates that GDP for the 3rd quarter is declining at .9% quarter over quarter or at a 3.6% annual rate of decline. If this trend continues there will be a very deep recession in Europe. This position is based on historical data showing the average Eurozone recession results in a GDP decline of only 2.2%, and during the Great Recession, the Eurozone GDP only declined by 4.3%.
The Eurozone economy has stalled over the last year, ending June 2023, with quarterly growth of only .3% and .6% year over year. In 2023, the ECB however raised rates another 2% and shrank the monetary base by over 900 billion euros or 14%. This is the largest tightening of monetary policy in Eurozone history.
The European Central Bank [ECB] has executed the largest and fastest monetary tightening in history by increasing rates by 4.5% within a year while shrinking the monetary base by over 14% in 2023 (as noted). Large monetary contractions normally cause recessions; as interest rates rise, the housing sector and other investment declines, and there are significant layoffs in these sectors. Consequently, given the magnitude of monetary tightening in Europe, it is not surprising that the Eurozone is entering a deep recession.
US Treasuries have performed in line with other benchmark bonds during the most recent sell-off. In our view, US-centric explanations are misguided although strong US growth does have global implications. We do not believe the Fitch downgrade materially contributed to the global sell-off.
We believe that the Fitch downgrade was appropriate as the Federal government budget process is broken as there is:
no balanced budget requirement and
limited restraint on profligate spending by both parties.
We expect, however, that the US external deficit of 95% of GDP with a deficit of 5-6% of GDP is manageable as the post-WWII nominal average GDP growth is over 6%, implying that the ratio of debt to GDP will be relatively stable over time.
It is noted that fears about treasury issuance post-debt ceiling agreement were largely unfounded as the Fed offset the issuance by reducing reverse repo to offset the increase in Treasury cash.
Stock Market Outlook:
We are currently neutral on the stock market as global interest rates have risen and we are in the weak Fall season. We expect the S&P to be range-bound in the 4,200-4,600 range during this difficult season. This view is however conditioned on the bond market stabilizing in the 4.5-5.0% area. Every 40bp move in the 10-year treasury affects the theoretical market multiple by one point.
We remain bullish on the market in the 4th quarter of the year. We have raised our target on the S&P to a range of 4,500-5,000 based on 18.5x 2024 EPS estimate of $245 on the low side of the target and under 21x at the high end. As the AI boom unfolds and many AI stocks move from being undervalued to becoming fully or over-valued, the market may trade to the high end of our range.
We believe investors can consider using preferred stocks to ride out the normal Fall storm.
The Dow is currently only trading at 16.5x 2024 earnings and only 15.4x non-tech eps. This is in line with our estimate of the fair value multiple of 15X at a 4.25% treasury. This indicates that the broad market ex-tech is fairly valued, with tech companies vulnerable to a pullback during the Fall.
The economy continues to be resilient and earnings estimates have only declined slightly.
Earnings estimates for 2023 and 2024 have been stable this year despite pundits predicting a dramatic decline.
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Fed and ECB Outlook:
The Fed absolutely should not raise rates again this cycle as we expect that data over the next two months will show a softening labor market, decelerating retail sales and continuing declines in reported inflation.
The recent rise in long-term rates could cause the housing sector to decline significantly, triggering a recession in the US. In addition, it should become obvious to the Fed that the Eurozone is headed into a deep recession that could be almost as bad as the Great Recession. We expect the ECB to cut rates during the first half of 2024 and the Fed to cut rates in the second half of 2024 as this Fed is always 12-18 months behind the curve.
The September Fed meeting was hawkish as the dot plot for 2023 was largely unchanged. The forecast for the Fed Funds for 2024 rose by 50bp to approximately 5%. The Fed statement did acknowledge that the labor market had cooled somewhat.
The labor market has decelerated dramatically over the last 3 months with private payrolls growth averaging only 140k vs. 222k over the prior 3 months, with over 60% of that growth coming from the health sector which is growing on a secular vs cyclical basis due to the aging population and Pandemic effects. The most recent jobs report also showed the unemployment rate rising to 3.8% from 3.5% and wage growth slowing to .2% from .3%.
The Bank of England [BOE] has launched an inquiry led by Ben Bernanke to determine what went wrong with the central bank’s policy framework that led it to miss the surge in inflation.
The Fed should launch a similar inquiry and revise its policy framework as it raised rates 3 months after the BOE. In our view, this supports our stance from last month that the Fed was even more incompetent than the BOE.
The Fed should change its policy framework by targeting a 2-4% range of inflation. The Fed should look at:
A variety of measures of inflation including both headline and core for PPI, CPI, PCE, and CPI-R
Be more attentive to leading indicators of inflation such as the money supply, housing prices, auto prices, and energy/commodity prices.
In our view, the Fed’s hardline adherence to the 2% target has made the Fed the primary culprit during this century in the decline of the middle class as the Fed attempts to depress nominal wages to hit their unreasonably low target.
There is consensus that the Fed should raise its inflation target, with a number of research papers supporting an increase and most recently a WSJ opinion piece from Jason Furman advocating for a 2-3% target.
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Inflation and Market Outlook:
Inflation is now contained even though the Fed does not recognize it:
PCE-R (PCE Core adjusted for market shelter prices) is currently 2.0% Y/Y and the last 3 months PCE Core annualized is at 2.1%
CPI came in at 3.6% y/y down from a high of 9.1%.
PPI is now 1.6% down from 11.7% y/y.
CPI-R (CPI using real-time shelter index) is now .9% down from 12.0%.
Housing prices are down 1.2% y/y but CPI is estimating that shelter costs are up 7.7% due to a flawed, heavily lagged survey methodology (only 1/6th of the index is updated every month and an outdated survey methodology is utilized)
We are bullish on oil but believe the current rally will stall out in the $90-100 range which will contain the impact on headline and core inflation.
Wholesale gasoline prices are down sharply over the last month and are now flat for the year.
The above indicators are real-time or coincident indicators of inflation with core CPI and PCE being deeply lagged due to slow bleed-through of energy prices and highly flawed estimates of shelter cost. PCE Core will only be down to 4.2% from 5.0% a year ago.
The PCE Index has a much higher weighting in medical services at almost 21% vs. 5% in CPI. This makes the PCE measure less desirable as Fed policy has minimal, if any, impact on medical services which is more driven by demographic trends.
The Fed’s focus on Super Core services is misguided as the high Super Core number is caused almost entirely by an increase in auto-related services. This increase in auto-related services is caused by the lack of new car production and available inventory due to a chip shortage. We believe this position is misguided because the Fed should not tighten monetary policy to attack supply shocks.
A prolonged auto strike by the UAW would be a minor negative as the elevated auto service components of CPI will likely remain elevated.
The leading indicators of inflation are
money supply growth,
and auto prices.
We forecast that inflation will continue to be contained as we believe that:
energy prices will stabilize,
housing prices are unlikely to rise significantly with 30-year mortgage rates at a 20-year high of 7.55%
and auto prices and services are likely to moderate as auto production continues to recover.
Recap on Historical Inflation Indicators:
During the 70s energy prices increased an unimaginable 1200% ($3 to $39), which caused 80% of the core inflation during the decade and housing prices rose an average of 10% per year. These two categories accounted for almost all of the inflation during the decade. Real wages declined by 6% detracting from inflation, which proves the labor market did not contribute to inflation.
Shelter and the auto sector represent 58% of core inflation. Goods prices drive wages, not vice versa, particularly in the US which is less than 6% unionized.
Inflation in the goods portion of autos is down with used car prices down 5.6% over the last year and new car prices now only up 3.5% while motor vehicle maintenance is still up 12.7% y/y and automobile insurance is up 17.8% y/y.
We expect oil to have a seasonal pullback when we enter the Fall as demand for refined products declines after the summer travel season ends. A decline would be positive for inflation as there is a 5% bleed-through of energy prices to the core.
Housing prices are down almost 1.2% year over year.
Chair Volker made a huge policy error by pursuing an ultra-aggressive monetary tightening to fight an energy price shock in the late 70’s.
We do not expect the Fed to cut rates until at least June of 2024 as this Fed is almost always a year behind in making the appropriate policy actions. Since the Fed should have cut rates after the banking crisis started in March of this year they will take at least a full year to discern that they should cut.
This Fed is fundamentally flawed as it focuses almost exclusively on the discredited Phillips Curve policy framework which focuses on employment and wages driving “inflationary expectations”, “wage-price spirals“, “entrenched inflation” and “Inflation that is more dangerous than a recession”. In our view, these conclusions are based on learning the wrong lessons from the 70’s oil price shock and are Urban Myths, often repeated but inaccurate.
This Fed completely ignores changes in the money supply which is a huge mistake when the money supply is extremely volatile, which it has been since Powell became Chair in 2018.
The money supply is 60% correlated to inflation since 2018.
The Fed’s assertion that persistent inflation is a bigger risk than a recession, is not supported by any research. Moderate inflation in the 2-4% is ideal for growth and nominal wages, and recessions are terrible for almost everyone. Very high inflation of 5-10% is a problem but that is not currently a risk for the US economy, and this type of inflation is usually caused by energy shocks, which are terrible for both inflation and economic growth.
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Commodity Outlook: We expect oil to trade in the $75-95 range while the Ukrainian war continues
We expect oil to trade in the $75-95 range while the Ukrainian war continues
Recent weakness in oil prices, driving prices below our range, was caused by
Tepid demand in China,
Fears of fallout from the banking crisis, and a
Slight increase in US production.
The ongoing European energy crisis is likely to offset weak global demand for oil.
The end of the China zero Covid crisis will result in a slow recovery of oil demand.
OPEC+ continues to support oil prices through production cuts.
The key global energy/climate opportunity is to rapidly develop the natural gas transmission and export capacity of the US.
There is a 70% discount on US natural gas prices relative to European prices.
Expanding natural gas consumption reduces the consumption of coal. Currently, coal represents over 44% of global carbon emissions.
High European natural gas prices are driving fuel oil/distillate prices through the roof as distillate can be used as a substitute for natural gas and is easy to ship.
The fastest way to reduce carbon emissions is to drill for more natural gas which will displace the use of coal by energy plants. It is not possible for the US to stop using hydrocarbons as wind and solar only represent less than 6% of US energy production and are extremely difficult to expand rapidly as siting/NIMBY issues are huge barriers to expansion.
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QUICK TIP: The remainder of 2023 is likely to continue to be volatile with Fed tapering reducing liquidity, inflation continuing, and growth slowing. We at InfraCap will remain focused on large capitalization defensive dividend stocks and preferred stocks that can have lower volatility and benefit from inflation.
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