Israel, Inflation, and Earnings

Jeff Buchbinder (00:00):

Hello everyone, and welcome to the latest LPL Market Signals. Jeff Buchbinder here for this week with my friend and colleague, Jeffrey Roach. How are you today, sir?

Jeff Roach (00:10):

A good afternoon here we are on east coast afternoon, and glad to be with you. It's been a few weeks, it feels like it's been a while, so glad to be back on.

Jeff Buchbinder (00:20):

Good to have you back. Yeah, normally when the weather turns, I'm jealous of you in South Carolina and I'm up in Boston, and it's certainly typically warmer for you at this time of year, but not so much today. So, less jealousy certainly for me. So here's our agenda for today. You know, given we have the CPI report, Jeff, I'm glad you're here with me this week. So we're going to talk inflation, but first, as we always do, we're going to have a recap of the markets.

Jeff Buchbinder (00:52):

Of course, everybody's watching the Middle East very, very closely. I think the message from the markets last week is that the war is expected to be contained. Now, obviously, we don't know where it goes from here. We're recording this on Monday, October 16, 2023. But at least the market's moving because you're seeing oil cooperate, you saw rates come down a little bit. Not, not dramatically, but you've seen rates come down. And you know, generally you've seen the stock market go up. So that's that. We'll also preview earnings because earnings season started late last week, essentially, with the big banks. So we'll give you our thoughts there and discuss what to watch. And then finally preview the week ahead, retail sales fed speak, and earnings, more earnings. So let's get into market recap first, Jeff.

Jeff Buchbinder (01:49):

So, S&P, you know, not a, not a huge gain, but a gain nonetheless up about a half a percent. The major averages last week were mixed, so you had some weakness in small cap, so a little bit of risk aversion, maybe showing up there, but not in the large cap space. And then you had you know, the Nasdaq do a little bit worse as well, down 0.2%. In terms of regions, we, you know, generally pretty good returns globally. The German market has kind of hung in there, I guess, recently, despite, generally, you know, markets believe Germany is in recession, or if they're not in one right this minute, they'll be in one quite soon. So it's some pretty good returns across the board, generally in Europe. Asia Pacific, you know, Japan stands out.

Jeff Buchbinder (02:44):

That's a market we continue to like, so good to see that, they give back a little bit of those gains over the weekend. But like that performance out of Japan, where you know, companies are really focused more on shareholder value. In terms of sectors, you know, we had the, some of the defensives react to the drop in rates. You'll see that on the next slide when we look at the bond returns. So you see solid gains in utilities, but energy was the biggest gainer for the week as oil prices rose on the Middle East conflict, but oil had come way down. So you know, it's still in the high 80s nothing that's particularly nerve wracking given we were in the 90s not long ago. I'll also mention consumer discretionary as an underperformer last week.

Jeff Buchbinder (03:37):

Now part of that is rising oil prices. But a pretty big chunk of it was travel and leisure, which makes sense given the turmoil in the Middle East and the shares of Tesla. Right? Such a big weight in consumer discretionary, it can lead the sector by itself. So that's why you saw some underperformance there. We continue in LPL Research to recommend industrials and energy as our favorite sectors. Turning to the bond market, we had gains really across the board in bonds as rates came down. Now part of that was likely a safe haven rally in treasuries as the Middle East conflict unfolded. But you know, might have been a reaction to the inflation situation as well to some extent. Jeff can weigh in on that. And then, you know, I mentioned energy was a big winner last week.

Jeff Buchbinder (04:33):

This is energy prices in the commodity index up 5% for the week. And then look at precious metals up five. We actually put a chart of gold in this week. Gold was breaking down technically two weeks ago, and then just made a sharp U-turn and is spiking higher. And you know, essentially, it's gone from oversold to overbought in a week, which is, which is pretty rare. So Jeff, what do you think about the move of bond yields and how the market reacted to recent inflation data?

Jeff Roach (05:12):

I think it was really interesting to think about how last week's performance was, when you drill into really the first half and the second half of the week, you know, after the Thursday morning inflation print things seemed to turn a little bit in terms of rates and performance. Just want to highlight one thing too we showed on the previous slide about international markets, and you're exactly right, Jeff. When you think about the overall activity in the economy you know, the German economy certainly has been what has some people have said "the sick man of Europe", you know, we've used that phrase. In fact, we used that phrase, you know, back, you know, over 10 years ago when we were working through the Great Financial Crisis. Same idea here as you saw some pressures in Germany really building over the last several months.

Jeff Roach (06:05):

So, it's yeah, I think it's unfortunately, you know, kind of a follow on to your discussion, Jeff, about the Middle East challenges. It's as if the market still seems to be mostly concerned and preoccupied with Fed policy and interest rate trajectory. I think that's where, you know, you kind of say, okay, that would explain why some of the reasons why the market seems to have been focusing and at least it's belief that the skirmish, the war, the atrocities are self-contained.

Jeff Buchbinder (06:42):

Yeah, good, good point.

Jeff Buchbinder (06:45):

So the market should price out rate hikes after the Middle East situation. And certainly, you've seen a little bit of that. So sure, a number of factors that probably contributed to rates coming down.

Jeff Buchbinder (06:56):

By the way, rates were also overbought. I'll show you a chart of this here in a minute. But first, let's go to the S&P 500. So, good news that the index held 4,200 that is, well, that was right around the 200-day moving average. Of course, the 200-day moving average is rising. So it looks like now it held 4,224, which it also did. So now we're into the Q4 seasonal period, which is very, very strong for stocks. We're in earnings season, which hopefully could cause markets to maybe look past what's going on in the Middle East as long as it remains contained. And you know, if rates come down, good chance we get that year-end rally, which on average is 4% in Q4. So this is a very encouraging chart. We'll see what happens at 4,400, which is right around the 50-day moving average and is certainly acting as resistance right now. But good to see the markets up nicely on Monday. What do you think?

Jeff Roach (08:04):

It's interesting, you know, people talk about Q4 seasonality, which is true. But if you go on the month basis, you end up seeing that October is one of the most volatile, if you look at month to month performance numbers.

Jeff Buchbinder (08:20):

Bear market killer in October.

Jeff Roach (08:21):

That's right.

Jeff Buchbinder (08:24):

Yes, good point. Right around mid-October, which is where we're sitting right now that's when stocks tend to turn and you start to see that year-end rally. October ends up being a decent month, you know, over the full 31 days, but really it's November, December where you get the seasonal lift. So you know, markets know that, and they're probably reacting to it a little bit ahead of time with this latest bounce. So you know, I mentioned we like, kind of like the chances of a Q4 rally. There's another tailwind here, which is the fact that we just started year two of the bull market. We mentioned this last week. So I just want to hit this home again because we have this table in the Weekly Market Commentary for today, which you can find on lpl.com.

Jeff Buchbinder (09:13):

It's kind of a two-parter earning season preview, and then a second year bull. So on average, a second year bull, which we just started on October 12, is up 12.6%, and it's been up every time. So that is certainly a reason to be constructive on the markets, at least for the coming year. The market continues to be very focused on yields. You know, remember higher yields means lower stock valuations, all else equal. So good news that we held the 5% level. I mean, you could, basically, 4.9% was resistance and that held and now we pull back a little bit right around 4.7 on the 10-year as we record this. Back to you know, support of the 20-day, still well above the 50-day. So we got to keep watching Treasury yields very, very closely. Some supply demand dynamics have been pushing it higher.

Jeff Buchbinder (10:11):

But the inflation story in general, as Jeff you've alluded to, should be, you know, capping rates here as the Fed pause approaches. It could be here already, if not, we think it'll be here very soon. And be clear to the market. You see in the middle panel here, the relative strength index of the 10-year Treasury was overbought over the 70 level and then came down, which is kind of following the playbook. Now you know, still kind of robust maybe at around 60, but you know, kind of settling in here, consolidating, if you will. And we think yields are probably steady to potentially lower. We did last week raise our 10-year yield target from basically from the mid threes to the mid fours. So we think mid fours is kind of fair value right now.

Jeff Buchbinder (11:03):

Last thing, there are a lot of institutions short treasury, so that from a contrarian perspective could mean we're close to the point where we want to buy them. And then oil you know, this of course is going to be the way the Middle East conflict translates over into a potentially damage to the U.S. economy. And the good news here is that oil has behaved very well still in the high 80s and doesn't really have much of a geopolitical risk premium. And at this point, this is the big difference between the 70s, right, Jeff, because we're, you know, we're self-sufficient with energy production now, and we certainly weren't back then. So that's why you saw the spike in oil prices in the 70s and the nasty recession that turned into two recessions and lasted a number of years. Very different environment.

Jeff Buchbinder (11:54):

So, you know, if oil goes up, it's going to hurt Europe and Asia probably a little bit more than it hurts the U.S. at this point, but it can still impact markets. So you know, the fact that we didn't break a hundred has created some technical resistance here. It's kind of the same story with yields, right? We were overbought, came back off the boil, and now we're consolidating. The bottom panel here is the is basically showing that the shape of the future's curve should be bullish for oil. You know, all else equal, and we do in LPL Research think oil's going higher, bullish on the energy sector, as I mentioned. So you know, we'll be watching this one closely and hopefully it doesn't go too high but certainly producers, Jeff, as you know, can be very profitable in the high 80s.

Jeff Roach (12:48):

Well, it's interesting too, you made the comment about the 70s. You know, it's helpful for our listeners to remember that, you know, oil intensity, particularly for the U.S. has declined pretty consistently. And that just means, by the way, oil intensity means how many barrels of oil does an economy use to produce whatever it does in its economy. So barrels per unit of output per GDP calculation. And it's quite fascinating to just see, you know, throughout the decades, the productivity and technological enhancements that have allowed us to be less sensitive to, you know, dramatic moves in oil. I think that could certainly be part of you know, the conversation, especially if oil doesn't settle back down. And the knock on effects from high oil to perhaps higher inflation. I don't know if that's going to be quite the natural progression as I just said. If you're interested in a little more of that research on oil intensity, the EIA and a number of private sector energy think tanks have done some really interesting, nice pieces of work on what oil intensity means for markets especially.

Jeff Buchbinder (14:11):

Yeah, correct me if I'm wrong, Jeff, but I think consumers only spend about three or 4% of their incomes on energy now. And at one point that was double digits. Does that sound right?

Jeff Roach (14:20):

It's, yeah, I think a little bit higher than that, but you're exactly right. That trend from, say the 70s, even the 80s and 90s from then to now has been a pretty nice straight line downward <laugh> in terms of the reliance on oil.

Jeff Buchbinder (14:39):

Yeah. So, you know, consumer discretionary sector and retail is reacting to higher oil prices. But the, you know, that transmission mechanism from higher oil to consumer spending has been weakened considerably. So thanks for making that point. Good point, Jeff. So here's gold. Here's this reversal I mentioned. Look at this U-turn. I mean, it's not even a U it's really a V. You know, gold was deteriorating, a series of lower highs, lower lows broke down and just looked awful <laugh>. And then, you know, turned out to be right at early 2023 support where it reversed with the Hamas attacks. And now you see just a straight line up, basically since then. So has broken out and broken this downtrend. So, you know, technically speaking, this looks good for gold. We did downgrade precious metals a couple of months ago to neutral. But at this point, based on this latest news, certainly the technical outlook for gold is positive. We'll see what happens with the dollar. It probably doesn't matter so much. Gold seems to change what it focuses on. You know, you don't have an overbought you don't quite overbought gold, but it's getting close with an RSI around 60. So let's turn to inflation. We mentioned a little bit about inflation, Jeff, but you've got two

Jeff Buchbinder (16:09):

charts in here this week. You know, one breaking down inflation between goods and services, and then your heat map, which is very interesting and really tells a pretty good story, I think for the inflation trends.

Jeff Roach (16:24):

Yeah, it's helpful to think, you know, as traders and investors seem to be preoccupied on what the Fed will do in November, what they will do in mid-December, and then of course the longer term plans in actual outright cuts, if that happens, the latter half of 2024. And it's all predicated on what we're seeing right now in the inflation data. And I think, you know, last Thursday was a little bit of a surprise on the headline. I think the best way to think about it is to say, okay, we know that if you look at that orange dotted line, durable goods prices, think furniture, think mountain bikes, and all the stuff that we splurged on during the depths of the pandemic have declined, those prices outright declining. You see that below the zero line, and it was, it was a massive debate on when the services would finally turn over and the service sector has turned over.

Jeff Roach (17:24):

We see that in the dotted, the blue dotted line. And it took some time, right? There was, that was kind of the period of the deepest of debates. Were we going to have a recession or not? Was the Fed going to continue to hike until, you know, we hit seven, 8%? You know, all of that conversation. And I think at this point, you know, if you exclude some of those line items, particularly in the shelter category, so rents, for example, you, we know that we're seeing an easing, a decelerating rate of growth in the services category. And one thing I'd just leave our listeners with is what markets care about is not necessarily the actual point level of inflation. If it's, you know, four and a half, 4.7, 4.2, whatever that number is, what matters for investors is the trajectory.

Jeff Roach (18:24):

Is there momentum going into and increasing or resurgence, or is there this momentum of a deceleration? So it's the rate of change that really matters. And we're seeing that. A little bit of surprise in some of the some of the numbers say like two months ago. But if you go to the next slide, Jeff, I think the key takeaway is we know from industry level data that rents have declined, and it's just a matter of time until that actually translates into the official government metrics. So I highlighted one to bring the listeners' eyes and attention to that middle line item there, the core CPI, excluding housing to take out the rent component, because we know that'll eventually ease because we're seeing it in the real time data. Core CPI ex housing 1.9% year over year.

Jeff Roach (19:25):

So not a bad number. The Fed is not going to say that they're declaring a victory by any stretch, but I think as investors, you look at, you know, where that trajectory is and certainly, it's moving in the right direction. I think, you know, I think the Fed pauses in November. It's now becoming a lot more of a consensus view now, several weeks ago it wasn't. So pause in November and there's still the likelihood of a pause in December, but that's still a little bit more of a, you know, a 70-30, 80-20 kind of play. But certainly inflation's going in the right direction.

Jeff Buchbinder (20:09):

Yeah, if the Fed just cared about core CPI ex housing, their work would be pretty much done <laugh>, right? So right. I mean, you've got a three month annualized number of around, what, 2.2, something like that. 2.2, 2.3. Yeah, it's just that stubborn sticky rent piece that's you know, standing in the way of an unequivocal pause that the market can aggressively price in. So, thanks for that, Jeff. This is a really good way to look at inflation and certainly we got a lot more green on the right hand side than we have on the left hand side, which is good.

Jeff Roach (20:49):

It shows up, you know, with the high oil prices, you know, we talked about how oil intensity in our country is pretty low, but when it actually hits, you know, gas prices, granted, it's a fairly small percentage of our overall spending, still, it's a psychological hit to the consumer. And that's really the darkest red, if you want to pick out, you know, where things are looking a little more tenuous, it would be that U.S. average of gas prices. But we don't think that that's going to be sustained for, you know, for a while in the upper threes. We've already seen that thing come down in the first few weeks of October. So even where we sit today on the 16th, we're going to be coming off that deep red. That was the only thing I wanted to highlight in addition to what I circled.

Jeff Buchbinder (21:42):

Sure. And you got to think if, given what's happened in Israel you know, certainly, the most deaths we've seen on any given day since the Holocaust over there, it's, you know, it certainly rivals the Yom Kippur war of 1973 in many ways. And yet, oil is, you know, what, 87, and it's been higher before this conflict even started. So I think this is a good story right here. And as you'll think about 2024 you're going to have a situation potentially where inflation is tame and rates start coming down as earnings are growing, and that all, you know, that can be a pretty powerful cocktail. This is not a formal projection for stocks in 2024.

Jeff Buchbinder (22:32):

But certainly, we're set up to potentially have a solid year then, consistent with the second-year bull market trend. So, let's go to earnings season now. Again, this is the Weekly Market Commentary for this week, which you can find at lpl.com. We think it's going to be a pretty good earnings season. You're going to have the earnings recession end, which is probably the main headline maybe three to 4% earnings growth year over year for the S&P 500. Now, and then from there, we think earnings growth will accelerate in 2024. Now, that said, the expectations for Q4 are probably a bit too high, you know, 9% earnings growth. So maybe those estimates come down a little bit, but we could still end up pretty close to, you know, the 220 number that, frankly, consensus has been centered on for like the past nine months.

Jeff Buchbinder (23:30):

I'll show you the estimates here in a minute. Now what are we going to be watching? So you know, the first thing is, it's going to be margins, right? We know revenues will be fine. As inflation comes down and at the same time, cost pressures ease. You have less pricing, pressure, but the potential to still support margins, right? With those cost pressure with cost pressures easing. So how that sort of translates, you know, the timing of that will be key. Now, the analysts are saying margins are going to go higher, so there's the potential for disappointment there. But you know, our best guess is that as a whole the S&P 500 is able to hit those margin targets for Q3. So that's certainly one thing to watch. From a sector level, we think energy will be really interesting to see, you know, oil prices were up 30% in Q3, gas prices were up too natural gas.

Jeff Buchbinder (24:36):

So when you have that lift plus companies just being more disciplined about how they invest and returning capital to shareholders, we think that's going to be a big winner this earnings season. The industrial sector will be important because it actually has seen the worst earnings revisions over the last month. Some of that's been UPS labor challenges there. Some of that has been Boeing, those challenges for Boeing are widely documented. So you know, outside of that, we think the numbers can be pretty good. We still like those two sectors. Those will be two we're watching. And then lastly the bar for techs really high, right? Remember these blowout quarters for NVIDIA, you know, AI chips, the last couple quarters have been some of the biggest earnings beats that we've ever witnessed in our multi-decade careers. Eventually, the bar gets too high, so we're not saying that tech's going to miss, but there's the potential for, you know, really good results to not be followed by a positive market response.

Jeff Buchbinder (25:44):

Hopefully that's wrong and that keeps going higher, but that is a sector where I would say the bar is high. So we'll certainly be watching that closely as well. So, you know, here's the S&P 500 earnings estimates 2023 and 2024. Another reason to think that this earnings season would be pretty good is because estimates have been so resilient. The 2023 estimate path is particularly remarkable because estimates on average fall about 10% during a given year. And this year they've fallen about five bucks. That's like a couple percent. Remarkably resilient in the face of intense inflation pressures. Granted, the economy's been resilient, but there's certainly challenges, right? Remember, we had some pretty big banks fail in March. So throughout all of these headwinds for corporate America, they've, you know, maintained pretty much the same level of profitability that even the most bullish analysts expected coming into 2023. So, this is a good story. Anything you'd highlight here, Jeff, on the earnings front before we preview the week ahead?

Jeff Roach (27:00):

Well, you know, as you're talking about, you know, the estimates going into this fourth quarter now and into next year, it's helpful for our listeners to remember, you know, last year, for example, a number of the layoff, the job cutting that was announced last year was all about firms managing costs. And so you think about how firms have entered into a potential, maybe, you know, a potential slowdown by the time we enter 2024. Firms are probably going to be in a pretty decent shape then if it you know, a recession happened so quickly, firms had, you know, just a lot of dead weight that they had to hit. So I think speaking of your margin conversation, which is spot on it seems like, you know, there's still that ability to find consumers willing to pay whatever they want to pay. They're not, consumers are just not as sensitive to prices as they were say, in, you know, pre-COVID. But you know, firms managing labor certainly seems to be one factor of supporting some of these numbers going into this quarter and next quarter.

Jeff Buchbinder (28:14):

Yeah, absolutely. You know, the strikes won't help, but you know, broadly speaking companies have done a great job of managing costs. And you know, it looks like a lot of those layoffs last year were just adjusting after over investment. Mm-Hmm.

Jeff Roach (28:31):

<Affirmative>

Jeff Buchbinder (28:32):

They weren't really about, you know, a weakening consumer environment or anything like that. So yeah, consumers, as long as they're getting paid and you know, have a job, there's probably a limit to how much they're spending will slow. And remember, we have, you know, basically the jobless claims trend, Jeff, as you know, and the unemployment rate are what used to be boom time readings, right? For many decades before the pandemic. So, what we have is like a boom time labor market, right? And we need, the Fed wants wage pressures to shut to slow, but I mean, the labor market is still tight, which means people have a job and people can still spend. So that's good for the economy heading into 2024 and good for corporate profits. We don't think the consumer will collapse, just continue to slow. So let's go to the week ahead, Jeff, and talk retail sales, Fed speak, and more earnings. I'll be real brief on earnings because we just talked about that. We have 55 S&P 500 companies reporting and of course, everybody will watch the developments in the Middle East as you know, Israel prepares for a ground invasion into Gaza. So what here should investors be focused on beyond certainly earnings and more?

Jeff Roach (30:01):

Yeah, yeah, I think, yeah, I think it's fair to say that investors can still expect to see market movements most closely tied to Fed policy expectations. We actually saw, you know, exhibit A today, Monday here the 16th, you know, the Philadelphia Fed President spoke and reiterated his view that the Fed funds rate currently as it stands is restrictive as it relates to the inflation rate. So, restrictive Fed policy means that in his view, the Fed can stop its rate hiking campaign. He is, by the way, a voting member of the FOMC, so his opinions matter. And so I think that was, you know, that was a little bit of a catalyst to see markets rally a little bit today because of the Fed speak. So, that's going to continue for the rest of this week.

Jeff Roach (30:59):

I think, you know, one of the things that you know, could be potential market moving, you know, numbers would be in the retail space. We'll get that on the 17th, Tuesday, not as comprehensive a report as the full personal income and spending release that we get when we look at the deflator, which is the Fed's preferred inflation metric. But, you know, this week will be certainly an opportunity to get a little more color in how Q3 ended. By the way, you remember, we've talked about this in weeks past. A number of Fed branches have their own model for forecasting everything from growth to rates to commodities to fed fund projections. And the Atlanta Fed was the most aggressive saying Q3 was going to be, you know, close to 6% annualized on the quarter.

Jeff Roach (31:56):

And that's pretty hot. I doubt that will come about. The other Fed banks were quite interesting. Some had negative numbers, some had, you know, kind of splitting the difference roughly 2%. But this retail sales release will help us get a view on the trajectory and how the consumer was feeling as we are going through this Q4 period of 2023. Clearly very important. A lot of holiday sales, people watch Amazon Prime Day, of course looking at the higher frequency initial unemployment claims to see how the consumer's handling this movement from what I've been calling the spending splurge. That's part of the reason why we have in our base case, you know, a slowdown at least starting maybe the end of this year or starting to be in next year.

Jeff Roach (32:54):

But it seems like the slowdown is not going to be anywhere near your traditional recession. This will be much shallow and short relative to those. So, looking at retail sales, I'll leave it at that. It's not a big, you know, it's not a big market moving week outside of earnings as you referenced, Jeff. That's why I think it was worth spending some time on this podcast, on the earnings component and then watching the various conversations that'll be happening throughout this week from voting members of the Federal Open Market Committee.

Jeff Buchbinder (33:32):

Yeah. So maybe the takeaway here is if rates are going to move, they're going to move on the Fed or potentially the Middle East. But you know, there's not a lot of data here that's going to move the economic growth expectations for the market too much one way or the other. Which is good for me because I like watching earnings and what companies are doing, you know, makes sense with my role as an equity strategist and not like you as an economist, Jeff <laugh>, right? But I would like, you know, dissecting what companies are telling us. So this is really you know, a fun time for me, and I think we're going to hear, you know, a lot, quite a bit of good news. So you know, hopefully the market can stay afloat. Hopefully the Middle East can stay contained and rates cooperate because if so we have the makings of a nice year-end rally. So with that, we'll go and wrap. Thanks Jeff for joining me this week. Glad to have you on for a timely discussion of that latest inflation data. Again, check out the Weekly Market Commentary on LPL com. We'll be back with you next week., Everybody have a wonderful week. Take care and we'll see you then.