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Mike Zaccardi, CFA, CMT joins James Foord for a discussion around the Fed funds market (0:30), whether we’ll achieve a soft landing (2:35), and why investors should consider having an allocation towards non-U.S. stocks (18:45).
This is an abridged conversation from Seeking Alpha’s Investing Experts podcast. Recorded on May 30, 2023
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Transcript
James Foord: Hello, everyone, and welcome to The Investing Experts Podcast. My name is James Foord, and I’m joined today by fellow SA contributor, Mike Zaccardi. Mike, thanks for coming on.
Mike Zaccardi: Thank you, James. Good to be here.
JF: A lot of people are looking at the recent rallies in stocks, calling it the S&P 5 since you have those five companies pretty much leading a lot of the gains. Now we had reasonably strong economic data coming out. And one of the things that I’ve seen a — we’ve seen a substantial repricing in the kind of Fed futures, and the idea that the next Fed meeting could give us another rate hike. Any thoughts on that?
MZ: Yeah, that’s exactly on point. So we look at economic surprises, really around the world, we see the United States Economic Surprise Index really ticking up. China has definitely turned lower. And we’ve had some unsettling inflation data over in Europe. And even Germany has now confirmed to have two quarters of negative GDP growth. So U.S. has kind of returned to the leading economic player, at least relative to surprises in the last several weeks.
And that’s bled into the CME Fed fund futures market, where we see, looks like more likely than not, another quarter point rate rise at the June 14th meeting.
And you know, right now, following the debt ceiling stuff, it looks like that could be it, but I expect — I think we’ll get that quarter point hike on June 14. And maybe that’s it. Either way though, we shouldn’t have too much change in the Fed funds rate during the back half of the year.
Market pricing is thinking, maybe December or January, in terms of the first cut. But you kind of look at the Fed funds futures market with a little bit of nuance, because it’s not as if the market is pricing in, let’s say, like one cut by January next year. It’s really pricing in the high probability of no cuts, or the low probability of several rate cuts, depending on if we get like an economic shock. That’s just sort of the bias of the Fed fund futures market.
So that’s something that investors should always kind of take with a grain of salt when they look at that market. Anyway, that’s just a little extra insight into the Fed funds market.
JF: That’s very interesting. You talk about that economic data coming out. I would love to know what your take is on perhaps, the next three, six, 12 months. Of course, we’ve had what I’ve called, the most announced recession in history, right? Everyone’s waiting for that recession to happen.
And like you say, we have had that data coming out, supporting the idea that perhaps the U.S. economy is a bit more resilient, that we could get that soft landing. History wouldn’t support that. But what are your thoughts? Do you think that we are going to achieve that soft landing? Or do you see us turning down?
MZ: Yeah, so that’s kind of the big question here. We’ve definitely drifted more towards that camp of a soft landing, even potentially no landing at all, which would be quite remarkable given the speed at which the Fed has hiked rates.
But let’s take a look at the data, right? So you’ve got the Atlanta Fed GDPNow model for Q2 tracking in the high ones. We’ve got consensus GDP forecasts for this quarter a little bit lower than that, but easily above 1%. It’s where we get into Q3, Q4 of this year, when the real expectations of an economic contraction hit.
It definitely wouldn’t be a long-term thing, based on everything we’ve seen now. But like you said, this recession kind of has been forewarned, like no other. And it keeps kind of getting pushed back as consumer spending data continues to run pretty decent. And the labor market, especially is running so high. We just really can’t have recession in that kind of environment. So we definitely need to see some evidence of changes in economic data.
I think if we get any of that it’s going to be fairly short lived. And the Fed has plenty of tools in their ammo right now, if we do see some kind of shock to support the markets, given that they’ve lifted rates so much. At the same time, the Fed is continuing on their quantitative tightening, which isn’t getting a lot of press right now. But that seems to be going fine.
Yeah, I’ll just be watching some of the big economic indicators out there. Of course, the monthly employment reports, but those tend to be extremely backward looking. We can keep looking at the leading economic indicators for signs of further weakness. That’s been maybe the most bearish economic data sets that we’ve seen as the LEI reports released each month from the Conference Board.
Claims data is important, obviously. Of course, we had that Massachusetts fraudulent claims snafu there a couple of weeks ago. But that that continues to look fairly sanguine. Retail sales is probably the area that will see maybe the most critiqued on a real-time basis. We do get a lot of high frequency data now on retail spending. And there’s a pronounced move lower over the last year among all income groups.
This summer, is going to be another period of revenge spending in the States. So it’s tough to have much of a recession if folks are going out on one last vacation binge. So I guess if we look towards September, October, November that could be the natural trough point of the economy as that final spending, push on vacation and travel wraps up. So that’ll be — that’s why I think it’s most risky point for the economy.
Now of course, the stock market moves ahead of the economy, right? So — and the stock market has been moving higher now, for the better part of eight months or so going back to the October low. So yeah, I think while the economic story is interesting, we do definitely have to focus on price action in the markets as investors.
JF: Exactly. That is a very good point. And speaking of price action, like you say, we’ve right a lot. I would also like to get your take on the more immediate effects on liquidity. Because I know a lot of people have been talking about this idea that, of course, now that the debt ceiling has passed, they’re going to start rebuilding that TGA that is going to drain liquidity out of the market. We still have QT going on. So to that extent with the markets overbought and what you might call some liquidity headwinds going forward, would you say that this is perhaps a time to sell or to take profits?
MZ: Well, I mean, I think certainly, if you’ve been overweight stocks for – especially technology stocks for this year, trimming some gains might be prudence. But in terms of the liquidity situation, we definitely see indicators in the market that bear out that, there isn’t a lot of risk taking on putting new capital into the market on the corporate side.
So you look at IPO activity this year, down huge. You look at debt issuance, among, especially among small cap firms are very, very weak. So corporations at least are taking all that into consideration. So it’s not as if we have a ton of companies refinancing debt at these very high rates right now.
You look at maturity walls for both investment grade and high yield. I mean, really, you got to go out a couple of years before a lot of that – those issues become — start coming due. So, that’s kind of a positive point for the corporate health checkup.
In terms of other liquidity, especially in terms of summer months, we should definitely see volume dry up across markets. So we could see some whippy price action on certain days as if someone looks to enter large positions that could move around individual stock quite a bit. And as long as we don’t have any more of these debt ceiling debacles, what I think could happen is interest rate volatility could start easing.
So if that happens, that could be a bullish offset to generally poor liquidity measurements right now.
So that’s one indicator I’m going to be looking at is that ICE BofA MOVE Index, which measures — it’s like the VIX for the Treasury market. That’s been incredibly high all this year, as the VIX has kind of settled back, the MOVE index is hovering above 120, which is very, very high.
So if we get a pullback in that index back under a 100, I think that could actually lends some confidence to corporate decision makers who are considering things like equity issuance and bond offerings this year. And it would certainly be a tailwind for prospective homebuyers, the United States looking to lock in a mortgage rate, because the lower rate volatility goes, the smaller the spread, and the average mortgage rate above the 10-year Treasury yield is. So if we can get that to happen, that would be a nice, like I said, bullish offset to kind of softer liquidity conditions.
JF: Right. Definitely, you make some very good points there. I think I find myself agreeing with you, especially on what you’re saying about the liquidity, that idea that, companies adjusting for this, and to the extent that there is already so much liquidity that you could say, so much debt that was taken on during that — or that COVID relief that maybe the market is fine with the “liquidity crunch” right, and it’s not going to suffer.
Now in terms of fundamentals, I would also love to get your take on the inflation debate, because we’ve got some very pretty clear data in recent months that we’ve got that disinflation. However, on the other hand, you could say while the economy remains too strong, inflation could get out of hand. Again, what are your thoughts on inflation?
MZ: Yeah. So if you look at some real-time readings on inflation, things are definitely looking better. A lot of the three-month annualized data points show maybe about 3% annualized inflation. And then if you include more up-to-date housing and rent data things from like Zillow, Redfin, Apartment.com and the like, we really see that the core services, the housing piece, which has been causing the Fed to get worried is looking a whole lot better. Of course, everyone knows that Fed uses CPI data that is — does not have very good up-to-date metrics on the state of the housing inflation perspective.
So, yeah, the real-time data is much more encouraging on the inflation front. So – and more broadly, if you look at the stock market reactions to recent CPI prints, I mean, they’ve been really a lot tamer this year versus last. So investors have gotten a lot more comfortable with where inflation stands. And it’s clear that inflation peaked in June of last year. So both the headline – well, the headline rate will have some struggles here in the next few months, because if you recall, oil and energy prices peaked in about mid-June of last year.
So once we get beyond the CPI report for July, we will then be comparing CPI year-over-year to lower energy prices. So the headline rate may not be coming down as quickly. But the hope is that the core rate, ex food and energy will start — will continue trending better. But the Fed is not going to be happy with a core CPI rate of 3% or 3.5%. They want to get down to that 2%, 2.5% target range. So those kind of 0.1, 0.2 percentage point movements and intervals are going to become increasingly important as we head into the back half of the year and into 2024, because like I said, 3% inflation doesn’t sound bad.
But the Fed does not want long-term inflation to restart at 3%. They want to bring that down to certainly 2.5%. And that’s what could warrant the Fed to keep rates in that higher for longer period. So that’ll be something to watch as the quarters progress here. But other than that, always focus within the CPI report at core services ex-housing to get a gauge of what the Fed is looking at. Used car prices are starting to show more pronounced downward movements after a bump up earlier this year. So that’s a good trend.
But wage growth data continues to be — one report is little hotter, one is kind of lighter, but wage growth is still pretty strong. And then one last thing the Fed pays close attention to on the inflation front are consumer expectations of future inflation. So that University of Michigan report that looks at near-term and long-term inflation expectation data, a survey of consumers, it may sound like it’s not important, but it is. People expect inflation to be high. They’ll demand higher raises at work and that’s a huge driver of inflation.
So those are some things to watch. Definitely encouraging signs on the inflation front. But yeah, the longer we go in time, those more the small intervals, the inflation rate are going to matter more.
So we’ve talked a lot about kind of the macro outlook. Obviously, tech stocks very hot right now. On the other hand, we have some sectors that maybe have been beaten down. Me personally, I think, we could look at those and maybe find some good opportunities. Commodities, like you said, peaked a while ago, and they’ve come down substantially. Of course, financials. Are there any sectors in particular that you’re looking at for the next few months that you think could offer some value?
MZ: Yeah, well, let’s take a look at that. So obviously, this year has been kind of the big three that we’ve kind of come accustomed to tech, comm services and discretionary. Of course, you back out Tesla (TSLA) and Amazon (AMZN) from discretionary and that sector doesn’t look quite as good. What I have noticed in a few charts lately, and this is kind of controversial. But in the regional banking space, we see some decent signs of a possible bottom there and just in some divergence numbers, technically.
Fundamentally, we still see very low valuations in financials and energy. Utilities have kind of pulled back on their valuation a bit. Healthcare has had kind of a weird year. They had that massive string of negative weeks. But then we saw a resurgence in Lilly (LLY) and then some flight to quality stuff with J&J (JNJ) that helped the sector. But in general, and you look away from those big five or so S&P stocks you mentioned earlier, and the market is pretty lousy this year, roughly flat when you look at Russell 1000, equal weight, S&P 500 equal weight, Russell 2000, cap weighted.
So, yeah, there’s just a lot of stuff not working right now. But the good news is earnings estimates are starting to come — it looks like come a little bit higher. We’ve seen some major sell side areas lift their ’23 EPS forecasts for the S&P 500. And we’ve seen current year EPS estimates kind of flattened out here to 220, give or take a few bucks. And then looking at the out year, looking more like 240 or 245, and that too has held steady.
So all those dire calls from skeptics earlier this year that S&P 500 earnings would have to come way, way down. That’s just not materializing. We’re not seeing that. And with the latest automation push and AI potentially driving, or at least sustaining margins where they are, I think we could definitely see upside to earnings estimates this year.
What that does to next year is hard to say. But if you throw an 18 multiple on 240 of earnings for next year, the market isn’t overly pricey here. And critics may cast shade on an 18 multiple, but the fact is, earnings multiples have trended higher over time. The U.S. market is more dominated by higher growth, higher-margin sectors today versus previous decades and relative to the rest of the world.
So in my opinion evaluation premium is warranted. So yeah, I see the overall market is kind of fairly priced here. But like the crowd, I was thinking at times last year that a deeper valuation reset was needed. And maybe we got that in October. At the October low, the market was trading around, I think 14, 15 times. I mean, that’s not trough level in terms of bear market multiples, but it was definitely a healthy pullback from 20-plus that we saw in 2021.
In terms of sectors though, boy, it’s hard to be fighting this trend in tech. You can look at some things such as relative outperformance gaps to try and spot when things get too frothy from a sector perspective against the market. But yeah, it really is kind of that 2020 theme right now of those big mega cap tech stocks is powering higher and we need to see signs that other sectors participate before you really want to start rolling dice getting overweight some value areas. And we’re just not seeing that yet.
So if we start to see more new highs, for example, in the value sectors, that would be helpful. But yeah, I mean, for the most part, it looks like this gravy train of the major tech stocks, powering the markets higher is going to keep going. So yeah, no real big insights into the sector over weights here. It’s just kind of more of the same feels like.
JF: Now before we wrap up, I would also love to get your take maybe on some of the international markets. I don’t know how much you follow those. But we have had, for example, the China reopening narrative, which was kind of very strong and we’ve actually seen China equities underperform.
On the other hand, we’ve seen very strong stocks in Europe, stock market there. But then recently, I believe, a week or two ago, we got data from Germany coming out suggesting or saying that the Germany is now in a technical recession. Any thoughts on those two in particular?
MZ: Yeah, a lot of cross currents right now in overseas markets. But price action is still in pretty good. So yeah, like you said, the China reopening is definitely not going as well as first hoped. Troubling data out in Germany, and then generally inflation out of UK and other parts of Europe, not good. But at the same time, we’ve got Japan at 30-year highs. We’ve got the German DAX, multi-year highs. So these are encouraging signs from a price perspective. It’s almost as if folks are kind of looking past some of these, I don’t know, maybe near term economic stumbling blocks.
And whenever you’re talking about international markets, you talk about the dollar. We do have the dollar moving higher here, which is interesting, given some still decent price action among overseas stocks priced in dollars. So that’s encouraging. So, for the first time in it seems like several years, we have international markets holding their own even with the remarkable run in concentrated U.S. tech stocks.
Used to be that when you had just the mega caps, the FANG, the so called FANG names leading the domestic market higher, we saw a terrible, alpha — negative alpha among international markets, but we’re now not seeing that anymore. So that’s a positive thing.
And investors overall are after 15 years of U.S. outperformance, investors generally are not all that enthusiastic about like Japan or German stocks, like these are not sexy areas. So I think there’s plenty of positioning that allows for further gains ahead for international markets. So for my investments, I definitely have a lot more international exposure than maybe most investors, U.S. investors at least.
So I would always urge investors to consider what the global market looks like. The global market allocation, kind of your base case for how you should deviate right now is about 60% U.S., 40% non-U.S. So if your allocation is 80% U.S. stocks, even though you have a 20% non- U.S. weighting, you’re still way overinvested in the U.S. market versus the global market portfolio.
So that’s something I like to dive into when I talk with the students at the university here, sort of the construct of the international equity market. But investors, I think, and just my opinion that they should have a good allocation towards non-U.S. stocks, some of which — some of those markets trade at very low earnings multiples, even if you account for sector differences.
So I know, Jeremy Schwartz and I chat on Twitter quite a bit about U.S. non-U.S. markets. And I definitely liked some of the work that Meb Faber does as well, analyzing that. So definitely an interesting area, and certainly some attractive markets on earnings multiple basis for sure.
JF: Exactly. Once again, Mike, I find myself agreeing with you a lot there. I’ve personally been looking a lot at international stocks as of late, given kind of what’s been happening lately. And to that extent, you make a good point in the fact that even though people talk about market breadth in the U.S. being kind of concentrated there, if you’ve maybe talked about market breadth, “internationally” you are saying, like the U.S. — the European stocks accompany the U.S. stocks in that way and that maybe a bullish sign of more good things to come.
MZ: Yeah, good point. Definitely.
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