The guest commentary below was written by Joseph Y. Calhoun, III of Alhambra Investments on 10/23/22. This piece does not necessarily reflect the opinions of Hedgeye.

Market Musing | Did Powell Just Blink? - 02.28.2018 Powell cartoon

Did Jerome Powell blink last Friday? It was just before the market open Friday and interest rates were jumping higher, as they had all week. The 10-year Treasury yield was up to 4.33%, another 11 basis points higher than the previous close and 32 basis points higher than the previous week’s close. Then, “the article” hit the front page of the WSJ:

Fed Set to Raise Rates by 0.75 Point and Debate Size of Future Hikes

By Nick Timiraos

The article led with this quote:

“We will have a very thoughtful discussion about the pace of tightening at our next meeting,” Fed governor Christopher Waller said in a speech earlier this month.

And just like that, the markets turned. Interest rates fell across the board – well, except for the very long end of the curve – and stock futures rallied. The S&P closed up 2.4% for the day and 4.7% for the week.

What does this mean? Not much unless the actual inflation data starts to improve. We’ll gain some clarity on the state of the economy this week when a lot of fairly important data will get reported.

We’ll get the CFNAI, a broad overview of economic growth relative to trend, on Monday. The last reading was 0 and the 3-month moving average is at 0.1 so by that measure the economy is growing right on trend (about 2%).

Tuesday we’ll get the latest Case-Shiller home price index (August) which seems highly likely to be down again. That will be seen as good inflation news but this report rarely moves the market.

Wednesday will see the release of building permits and new home sales and that will likely be weak but not surprising. Thursday we’ll get the preliminary Q3 GDP report which may be surprisingly upbeat if the Atlanta Fed’s GDPNow is anywhere close to accurate (last reading +2.9%). There will be inflation data within the GDP report but it’s old data so might not mean much. We also get durable goods orders Thursday.

The big day is Friday when we get personal income and spending, the employment cost index, the PCE price index (the Fed’s preferred inflation measure), and the final look at the University of Michigan consumer sentiment report (which has an inflation expectations component).

We are also in the Fed’s blackout period prior to their next meeting so we won’t hear any of the Fed governors opine about this data. I suppose if something on the inflation front is really out of line with expectations, we could see another leak to the WSJ but frankly, I’d prefer the Fed just wait until their November meeting. I am, like everyone else I assume, exhausted with the Fed’s open-mouth policies.

So, we’re going to get a good snapshot of things next week. There are various other reports mixed in but most of them are not the market-moving variety. But with markets as twitchy as they’ve been, who knows what the market will choose to focus on.

Will any of the data matter for the course of the Fed’s tightening? Maybe. Even Powell apparently decided last week that the market was taking things too far or he wouldn’t have approved that WSJ story. And yes, I absolutely think he had to approve it.

I have said for weeks that the Fed needs to slow the pace of its tightening campaign. It is nice to see some folks with more gravitas than I – like Jeremy Siegel – join that call. Will it matter? I suspect it will only if the inflation data cooperates.

In the meantime, corporate earnings are being released for the quarter and so far they aren’t that bad. With everyone scared to death that earnings estimates are too high, it doesn’t take much good news to move individual company stocks and the market as a whole. We’ve only seen about 20% of the S&P 500 report yet though so there’s a long way to go.

What we’ve seen so far is 72% of companies beating estimates which sounds good but is slightly below the 10-year average of 73%. Revenues have been better than expected at 70% of reporting companies which is well above the 10-year average of 62%.

The problem? Net margins are down for the 5th quarter in a row (assuming current trends continue). They are still historically high at 12.2% (that’s higher than all of 2018 for instance) though so the damage hasn’t been that bad. Companies have, so far, been pretty successful at passing on their cost increases.

Energy, industrials, and real estate are the largest contributors to year-over-year growth so far. Energy probably doesn’t surprise anyone but industrials and real estate might.

For industrials, airlines went from a $731 million loss in Q3 last year to a $2.9 billion profit this year. 7 of the remaining 9 industries in the sector reported earnings up greater than 10% including aerospace and defense (+28%), construction and engineering (+23%), machinery (+20%), road and rail (+18%), and electrical equipment (+12%).

We think there are good reasons for industrials to be performing well and expect it to continue (you might want to download our special report to see why we think so).

Real estate FFO (funds from operations) is up 18.1% year over year, third highest of the 11 sectors, led by hotels and resort REITs (+99%) and industrial REITs (+90%). This is why we continue to hold REITs despite a drubbing this year. We knew that they would take a hit from rising rates (although we didn’t expect this bad) but in the long run, real estate performs well in inflationary environments.

The consensus seems to be forgetting that earnings are nominal and if you have NGDP growth you are going to see revenue and earnings growth. That was true in the 1970s when earnings were generally robust in nominal terms. There were only 8 months during the entire decade when year-over-year earnings were down more than 10% with the worst in September 1975 (-14.8%). Earnings continued to grow through the recessions of 1973/74 and 1980.

The question isn’t earnings but what interest rate we use to discount those earnings.

That’s why in previous inflationary periods stocks bottomed when inflation and interest rates peaked. Will this time be like the late 60s and 70s? I tend to think so and I think inflation already peaked. We’ll find out more this week.


Joe Calhoun is the President of Alhambra Investments, an SEC-registered Investment Advisory firm doing business since 2006. Joe developed Alhambra's unique all-weather, multiple asset class portfolios. This piece does not necessarily reflect the opinions of Hedgeye.