Looking Back and Forward Recap of 22Q3:
During the 3rd quarter, the US equity market lost ~4% of its value, with the large market capitalization stocks underperforming the SMID segment. Underpinning the declines are: 1) sticky, broad based, high inflation, 2) a more hawkish Fed convincing the market participants interest rates will be higher for longer, 3) stunning appreciation of the US dollar against other major currencies, 4) resilient US consumers with abundant job opportunities, rising wages, and significant savings.
July CPI rose 8.5% y-o-y, lower than the 9.1% y-o-y growth in June. CPI in July was flat from June, after rising for 25 consecutive months, mainly attributable to lower energy prices. Core CPI, which excludes energy and food prices, grew 0.3% m-o-m, down sharply from June’s 0.7% gain. August CPI, however, rose again, up 0.1% from July (8.3% y-oy), while core CPI rose 0.6% from July (6.3% y-o-y), both higher than expected.
August CPI data dusted off hopes that inflation may commence on a downward trajectory after July’s pause. The Fed raised the fund rate by 75 bps in July and September respectively, to a range of 3.0- 3.25%. In September, the Fed signaled additional large increases are likely on the horizon even though the risk of recession has grown. Nearly all 19 Fed officials expect to raise rates to 4% – 4.5% by the end of this year, suggesting sizable rate increases at policy meetings in November and December. Officials projected that rate rises will continue into 2023, with most expecting the fedfunds rate to rest around 4.6% by the end of next year. That was up from 3.8% in their projections this past June. Around one third of officials expect to hold the fed-funds rate above 4% through 2024, while others anticipate more rate cuts.
With the Fed pivoting to a more hawkish stand, and the committee’s latest dot plot materially exceeding expectations, market participants are finally convinced it was wishful thinking that the Fed might start cutting rates in early 2023. On the contrary, interest rates will rise higher and stay high for longer.
Real Yield and ERP: The Fed’s more aggressive action and messaging seem to be working in bringing down inflation expectations. Five and 10 year breakeven inflation rates ended 22Q3 at 2.14% and 2.15%, down from 2.6% and 2.3% in June and the peak of 3.59% and 3.02% in March/April. With 10-Yr US Treasury yield ending Q3 at 3.8%, the 10 Yr US Treasury real yield rose from 0.65% to 1.68% in Q3. For a point of reference, from 2003 to 2007, the 10 Yr real yields hovered around 2%.
*Source: St. Louis Fed
10 Yr US Treasury Real Yield (12/2002-10/22)
*Naqdaq Data
All things considered, the US equity market’s 4% drop in Q3 was a rather benign response to a sharp increase in real yield, we believe. We have always stated that, from Applied Finance Market Derived Discount Rate (MDDR) perspective, the discount rates for the US stocks have always been “healthy” due to lofty equity risk premium (ERP). Applied Finance’s real MDDR for industrial firms were just slightly below 5% in 2020 and 2021, despite the 10 Yr real yield in the negative territory. Equity investors have always demanded an adequate return for the risk they were taking. From 2003 to 2007 when the 10 Yr real yield was at a reasonably normal 2%, Applied Finance’ real MDDR ranged from 4% to 5%. Right now, the MDDR is slightly above 5%, with the real yield approaching 2%. The current MDDR is comparable to the 1994-1996 levels, when inflation expectation and 10 Yr US Treasury yields were much higher, meaning the current MDDR implies a much higher ERP. Maybe back then the market had a lot of more confidence in the Fed’s interest rate hikes, which brought the fed fund rate from 3.00% in early 1994 to 6% in early 1995. The US GDP grew 4%, 2.7%, and 3.8% respectively in 1994-1996. Fast forward to right now, the market likely doesn’t have as much confidence in the Fed ‘s ability to bring down short term inflation or engineer a soft-landing. As a result, ERP is materially higher today.
Soft-landing or Not: We must note while the consensus 2022 EPS estimates for the SP500 have risen from $223.43 at the end of 2021 to $227.80 at the end of March and to $229.63 at the end of June, they were finally revised downward in the 3rd quarter, with the latest estimate being $224.38, a 2.3% decrease from June. The 2023 SP500 EPS estimate was also revised down to $241.83 from $250.60, a 3.5% decrease. Those latest earnings forecast, are implying an economic soft-landing, not an outright severe recession. Historically, the SP500 EPS change during a recession was a decline in the high teens. That said, with the SP500 losing nearly a quarter of its value YTD, investors clearly have embraced less robust prospective earnings than what the consensus estimate is suggesting. The Fed has stopped talking about soft-landing. Instead, they stress the importance of lowering inflation and achieving price stability, at the cost of “some” pain. We are still rooting for a soft landing or a shallow recession, and we know we belong in the minority camp. The story for a resilient US consumer remains intact: unemployment is low (3.5% in September, with nonfarm payrolls increasing 263,000, though less than the estimate of 275,000. A drop of 25,000 in government jobs was a big contributor to the miss, while job gains on the consumer and corporate side are still resilient.), jobs are abundant (1.7 job openings for every available worker in August, though down from 2 jobs per available worker earlier in the year), savings are flush (much of the $2.5 trillion savings remain unspent), consumption is strong (August retail sales grew 0.3% from July, outpacing the CPI increase of 0.1%). It is probably wishful thinking, but we are hoping for some long-awaited supply relief. The Fed’s interest hikes seem to have limited impact on reducing near term inflation by reducing demand. It takes two to tango and it takes more than the Fed to bring down inflation. We need supply relief. We need commodity prices to drop, many of which have, such as copper, lumber, grains, but we need more reversal to core goods prices. Maybe China’s Covid policies will loosen after October? Maybe the war between Russia/Ukraine is closer to an end now Ukraine has made significant gains in the south and east, and Putin seems to be out of options? We really need supply chain to revert to normal.
The Valuation 50 will continue to focus on owning undervalued stocks in its SP500 universe, while maintaining broad sector exposure and industry diversification. With the third quarter’s earnings season around the corner, we are curious to find out the latest operational results. Our models have generally assumed a moderate GDP growth environment for the near to midterm, though adjustments have been made to reflect unwinding of Covid era exuberance for companies in targeted industries. We are curious to hear our management teams discuss their outlook for the next year, a new normal, and new normal growth rate, if any. We remain confident in our holdings’ ability to adapt to and execute well in whatever macro environment the future may present. We continue to rely on a healthy valuation buffer to protect us, should our projection fall a bit short or the cost of capital increases from the current levels.
