Jerome Powell about three weeks ago, “More recent data shows solid growth and continued strength in the labor market, but also a lack of further progress so far this year on returning to our 2% inflation goal,” the FED chief said during a panel discussion. At the beginning of the inflationary cycle, the FED put itself in a very difficult spot by acting too late in hiking interest rates because it thought inflation was transitory. To make things more complicated for the FED, recent economic data shows inflation is accelerating, unemployment is ticking up, and GDP growth is slowing down more than economists and the FED itself anticipated. This is described as Phase III in the economic cycle, where inflation accelerates and economic growth decelerates. The risk is now stagflation, where inflation accelerates with higher unemployment and lower consumption. Unfortunately for the FED, hiking interest rates is the most efficient way to fight inflation, but at the same time, it will make things worse for consumers and businesses.
As you would expect, Phase III may bring uncertainty for investors which increases volatility. Most of the time, volatility and the stock market move in opposite directions. As volatility increases the stock market moves lower and vice-versa. This is the time in which having a proven and active risk management model is of utmost importance. For those of you who are new to this page, I should mention that our risk management model has successfully called every single bear market since the internet bubble, followed by the mortgage crisis and COVID-19.
For clarity (I’m being sarcastic) let’s look at the last two meetings of the FED, March 20 and May 1. At the end of both meetings, the FED left the Fed Fund Rate (FFR) unchanged at 5.25%-5.50%. This is a 23-year high. In my opinion, the bias expressed by the chairman was mixed or even confusing in March and May. At the end of the March meeting, it seemed he was expecting inflation and GDP to accelerate. This is Phase II in the economic cycle and stocks move up during Phase II. Regardless, he mentioned they expect to cut rates, and investors estimated three times before the year’s end despite solid growth, firmer than anticipated inflation in recent months, and a solid jobs market. During Phase II the monetary policy bias of the FED is hawkish, not dovish and the shape of the yield curve is normal where short-term interest rates are lower than long-term rates. However, the current shape of the yield curve is inverted where short-term rates are higher than long-term rates. I’ve said it before, I have trouble reconciling the bias of the FED with what the bond market is telegraphing to investors. Therefore, my sarcasm.
What is the economic data telling us now? The actual first quarter (Q1) GDP reading came in at 1.6%, compared to 2.4%, estimated by 69 economists surveyed by Bloomberg and the FED. Personal Consumption Expenditures (PCE) Index, which is the preferred measurement of inflation and deflation followed by the FED, rose to 2.8% in March. PCE in Q1 accelerated to a 3.4% annualized rate. PCE is a measure of core prices that excludes volatile food and energy.
Initially, during the month of April Treasury yields moved higher again despite weaker-than-expected GDP growth (1.6%). It makes sense given the current scenario: worse-than-expected quarterly inflation and the strength of the consumer (PCE 2.8%). I would argue that a 1.6% GDP growth would normally trigger the case for easing interest rates, or at least the thought of it together with a dovish bias from the FED, but not under the current economic conditions. I mentioned in my last article, I have trouble understanding how investors expect an interest rate cut while inflation is above the FED’s target even if economic growth is lower than expected.
Fast forward to the FOMC (Federal Open Market Committee, the FED) meeting on May 1. In my opinion, Jerome Powell mastered to deliver a vague message. Was he more hawkish or more dovish than before? I’m not sure and I’m quite certain that many traders don’t know either. This is important because, after each meeting, the FED’s decisions and verbal statements affect the cost of borrowing capital for businesses and individuals, the value of assets (sometimes creating bubbles by artificially inflating prices), and the strength (or weakness) of the US Dollar.
The three economic variables I’m discussing in this article are important for stock market direction. That is economic growth, inflation, and the FED monetary policy. These are not the only three variables in our risk management model, but let’s focus on them for simplicity in understanding what the model is currently showing. We now know two of the variables: inflation and monetary policy. Inflation is higher than the FED’s target and the worst case is that it may even accelerate by year-end. However, most economists expect inflation to cool down. But we all saw how well the 69 economists surveyed by Bloomberg and the FED did in forecasting the last reading of GDP growth (go back to the fourth paragraph above). Monetary policy, after the statements at the end of the last two meetings, is vague or confusing. In my opinion, it is vague and confusing because it is a presidential year, and perhaps no one wants to lose their seat at the table. Therefore, in my opinion, and unless it is absolutely necessary and unavoidable, the FED will not hike interest rates until the election date on November 5th. I sincerely hope the FED continues to be apolitical, but I doubt it. If I’m correct, this helps the bull case for stocks.
The third component in determining stock market direction is economic growth. Our risk management model continues to show the stock market under selling pressure short-term, but still overall bullish in the longer term. Therefore, I believe it is safe to assume that the model is not seeing GDP collapsing. Perhaps slowing down more but reaccelerating later on.
This is important because after removing all the noise and confusing news and forecasts, it means that the US economy will be rotating between Phase II and Phase III in the economic cycle. Again, the former is when both growth and inflation accelerate together. The latter is when growth decelerates and inflation continues to accelerate (risk of stagflation). Historically, neither one of these two scenarios has been negative for stocks. The trick is where you invest your money. The icing on the cake would be if, at a certain point, the economy hits Phase I. This happens when growth accelerates with decelerating inflation. This is the ideal time to take on risk and deliver serious performance, the goldilocks.
Conclusion: We remain cautious and expect a pullback or correction within Q2 and possibly even Q3, but overall, we are bullish for 2024 as long as the FED does not have to hike rates. With the information we currently have, the chart below shows the expected levels of support for the S&P 500 Index if the sell-off we’ve experienced between April 4th and April 19th resumes. Short-term, the index needs to close above 5130 (Friday’s closing price was 5127.79) to give the bulls a better chance at challenging the March/April high at 5260. The April low at 4950 is the first line of support followed by the 4850/4800 area.
Please remember that our forecast may change as economic data becomes available.
Consider not being fully invested, taking on smaller position sizes, and holding a higher cash allocation.
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Check the Main Trends of stock indices, volatility, yield, currencies, and more here.
(*) The Greenwich Creek Capital “Index Trend Table” is not meant to be used in isolation, it is part of a more complex set of variables and it is not designed to provide trade entry and exit points.
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