High Note Market Update: Friday, March 3, 2023

5 minute read | March 10th, 2023

Happy Fri-YAY, peeps! It’s been a while. Hopefully you’ve missed this note as much as it’s missed you. Since the last time, we can summarize the world of investments with the old adage, “the more things change, the more they stay the same”. Or if we want to use the financial parlance of the day, we can say that investing environments are cyclical and this cycle of rates going up, inflation persisting and stocks going sideways is still in full
bloom. The interrelation of these things is what we are going to discuss today.

Inflation: One single word that, right now, carries more weight than any other in all of finance. It’s really been the only story for the past year and a half. It appears that this story will continue indefinitely as it has reduced, but it will not seem to go away.

On a base level, inflation is a very simple dynamic to understand – you only
have to look at your grocery receipt one time see it happening in real
life. However, it’s good to do a quick refresher on its links to other parts of
the global economy and why it is such a big influence on markets.

Interest Rates: When inflation is over the Federal Reserve target of 2%, they raise interest rates until it comes down. Simple as that. It’s in their mandate as an organization to do so because they know that a sustained period of high inflation causes recessions, depressions, and economic destruction. How, you ask? Great question, you. That brings us to the next relation…

Corporate Earnings: If we eliminate the wealthiest 15% of the country (everyone reading this note), most households are very price sensitive. This cohort’s housing, food and energy costs represent an extremely large portion of their income. When a dozen eggs triples in price overnight, sacrifices and substitutions must be made. Most can work around it for a short period, but the window is small. What gets cut first is anything discretionary – clothing, dining out, movies, iPhones, travel, Target stuff, new cars, etc. Buyers can then make substitutions in where they shop (we call this “trading down”). Something like this order – Target > Walmart > Dollar General. This can buy a little more time but it’s not sustainable. The effect of this buying behavior is a hit to corporate earnings. At first, the pure discretionary stuff sees a dip but, over time, it pervades all earnings in some manner. Lower earnings hurt stocks, which we will discuss in a moment, but let’s continue that thought on corporate earnings.

When a Fortune 500 company has poor earnings for a quarter, it doesn’t
necessarily blow them up but it definitely grabs attention. If that repeats
for a couple of quarters and drags into the year, it’s bad news for
leadership. Why, you ask? Another great question, you!

I’m not saying that corporate finance is a house-of-cards, however, at
times it does resemble a fun little project where you take a 52-card deck of
playing cards and delicately stack and balance them into a tower on the
table. That said, the corporate houses do have a pretty strong force field
of protection and that is one word – growth.

Growth is the straw that stirs the drink. It pleases investors so you can raise more money. It pays the piles of debt you’ve racked up on the balance sheet (corporate America is about as responsible as the Federal Government in terms of using debt to cover current spending). Growth also allows you to pay dividends, buy back shares and expand. And there’s one more tricky little thing. Management compensation is explicitly and directly tied to growth.

Corporate compensation through shares, bonuses and incentives is a crucial piece of this puzzle. Right or wrong, this is how the game is played. It used to be that a lot of corporate compensation was tied up in deferred payments like pensions but that’s no fun because we want our money now and so changes have been made. This newer set has worked fine as long as there is a nice tailwind of growth. Replace that tailwind with a headwind of inflation and things get tougher.

When the growth outlook turns challenging, focus immediately turns to earnings. You can still have positive earnings even if you are selling the
same or less if you reduce expenses by a commensurate amount. That
sounds easy enough. But what that translates to is projects being delayed, marketing budgets slashed, hiring freezes, compensation cuts and ultimately layoffs. Said another way, decisions are made to make things look decent today, but are not helpful for tomorrow. Like the “trading down” that buyers do during difficult times, the corporate version is to tighten their belts. This can work for a short period of time but it’s only a temporary fix.

In the past couple of months, we are seeing examples of this. To this point,
the layoffs have mainly occurred in the tech industry, but cost-cutting is a
topic addressed on many of the recent earnings calls. One way or
another, the earnings must be protected because…

Stocks: You’ve probably heard us say that the stock market is a forward discounting mechanism. That’s just a fancy way of saying that companies are priced on what they will do tomorrow, not today. As in, when we buy a share of a company, we are getting a piece of their future earnings and everything is priced as a multiple of that. So if earnings are flat, prices are then…flat? Not quite. Prices people are willing to pay always have some assumption of future earnings growth. Take the assumption of growth away and prices go down on flat earnings. It’s this interaction that caused the stock market pullback in the second half of 2022.

As we sit today, inflation continues to be a problem. One month we will get
a report that it’s cooling off in some areas only to have it pop back up somewhere else the next month. Regardless of where the inflation is occurring, we know that if it’s present, the Fed has no choice but to try to bring it down by increasing rates. What Chair Powell and associates are trying to do is thread-the-needle of taking rates up enough to tamp down
inflation but not too high to break stuff. This is a very, very difficult task. It
hasn’t been done before but that doesn’t mean it’s impossible. This game
of cat-and-mouse has been playing out for the last year and continues today.

For investors, these conditions can really be okay. Short-term interest rates
are fantastic. Money markets are yielding close to 5%. 1-Year treasuries are
5.2%. Dividend paying stocks can still make positive returns in sideways markets. So while there may not be a shiny growth forecast that will
brighten everything, these times can be navigated as we watch closely all
measures of inflation and the Fed reaction to said inflation.

Gold star if you made it this far! Great to be back writing. All the best.