The End of the Hiking Cycle
The GDI recession is over, Fed awakening, services wages cooling, revisions rising.
The GDI/Earnings Recession is Over
This week’s 2Q23 GDP revision included the first look at GDI, after a 3.3% quarterly annualized decline in 4Q22 and a 1.8% contraction in 1Q23, it increased 0.5% in 2Q23. The nominal net operating surplus of private enterprises contracted for a fourth consecutive quarter, and the BEA’s corporate profits measure contracted for a third quarter, however, like S&P 500 earnings, the rate of decline turned higher. From an equity investor’s perspective, the recovery in earnings is a powerful catalyst and as we will discuss later in the note, analyst earnings revisions are trending higher ahead of conference season. Meanwhile, the majority of Federal Reserve System economists, who also dominate investment banking econ departments, appear to have been swayed by the preponderance of evidence that demand for labor has softened, disinflation is not transitory, and the reduced supply of credit is a systemic risk, conclusions we reached in late ‘22 and early ‘23. In other words, we are headed into a period of positive earnings momentum and reduced monetary policy risk.
The misunderstood Atlanta Fed GDP tracking model’s early 3Q23 surge likely marked the highwater mark for the convergence of equity and fixed income investors fundamental outlooks. By the time 3Q is complete, the labor market and consumption outlooks are likely to have deteriorated markedly, economists will be marking up the probability of recession, the rate hike cycle will be done and dusted, and the belly of the Treasury curve is likely to rally to the top of the range (~3.75% for 10-Year USTs). The coming growth scare will likely cause another brief equity market risk-off episode, likely from a higher level, which should be bought. Another way to think about the dichotomy in outlooks is that ‘bad (data) will be good (for the markets)’ until we get confirmation the rate hike cycle is complete. Once that occurs, most likely at the September meeting, the majority of market participants will assume the Fed went too far, without an understanding that the recession they have been obsessing over through the hiking cycle, already occurred.
The reaction in the long end of the Treasury market (bear steepening) to an optimal August employment report was curious. We suspect the pullback was driven by a price concession to absorb post-Labor Day supply. We are in September now, and as we all now it is volatility season, however, this week’s labor market developments were unequivocally favorable for the monetary policy outlook. Consequently, the probability that the August risk-off episode, attributable to the supply driven bear steeping of the real (TIPS) Treasury curve, has run its course, is high. We would put some money to work, see our sector allocation at the end of the note for our preferred sectors. With the exception of financials, we remain overweight economically sensitive cyclicals.