Stock Talk - Inflation, Real Interest Rates, and Market Turbulence: What Investors Need to Know

Starting point is 00:00:00 Investors on February, January 20th, last year. When investor pessimism rampant in calls for a market retest, a 3,500 or lower throughout the strategist's land, and the S&P 500 trading around 3,900, I released a video titled, Two Things That Really Matter. The link to that video will be in the description below. Our investment team had been talking positively about our expectations for 2023, but back then, few people seemed to be listening. We had already published our 2023 Outlook and followed it up with a stock talk titled,

Starting point is 00:00:32 What Could Go Right? We gave a few reasons for our optimism during a period of uncertainty, backing it up with historical statistics combined with real-time data series. I felt uneasy releasing this video back then, and I've been doing this investment management gig for almost 30 years. As it turns out, our outlook for 2023 turned out pretty close to spot on in both price and time throughout the year, including the summer sell-off and calling for the fourth quarter lows in Pivot Hire almost to the day of our October 26th live stream. You can also find that link to the video with myself, Troy, and Charles, discussing the likely strength of the fourth quarter coming from November through year end. Investors in this week's video, I'm returning to the exact same topic I addressed on Friday, January 20th a year ago. Its title back then was What Really Matters.

Starting point is 00:01:23 This week, its title, The Two Things That Really Matter, Revisited. So, investors, what really matters here? What two things above all else matter to investors? It's the same two things that matter most often as far as I see it. And those two things are intertwined, of course. First is inflation. Both its level, whether it's absolutely high or low, and sometimes more importantly, its trend.

Starting point is 00:01:46 Is it rising or falling from a high or low level? And secondly, the level and trend of real interest. rate component within nominal yields. This is also called the tips interest rate. This is the one that most strategists finally discovered and started discussing as critical, almost universally in a negative manner, near the market lows in late October of last year, right in front of the roaring late fourth quarter rally. Remember investors, all of those CNBC and Bloomberg interviews with strategists spouting the Fed's higher for longer message. We're discussing some academic notion of R-Star, whatever that.

Starting point is 00:02:23 is right at the market lows in stocks and highs for bond yields. Unlike many others, we've spoken about real interest rates and real-time inflation for over two years now. We'll cover them again right here. Real-time inflation and real-time real-interest rates. And unfortunately, opposite of January 20, 2003, they're currently saying that seasonally curb your enthusiasm here and there's likely a pullback that's likely coming fast and furious in the first quarter. Let's cover it again. Overall, goods inflation peaked in late first half in 2022. Commodity pricing slumped, used car pricing collapsed, container shipping rates collapsed, most industrial metals round-tripped. The price of lumber dropped 75%. Fertilizer, oil, natural gas prices all plummeted,

Starting point is 00:03:13 even with the war in Ukraine and energy shortages in Europe throughout the second half of 2022 and the first half of 2023. Back in January of 2023, we shared with you the data about peak inflation. Here's that great chart from Barry Bannister at Stiefel Financial, showing the lead times for peak CPI first, the lows and pivot up in the SEP 500.

Starting point is 00:03:39 Since World War II, the average length of the lag was seven months after peak CPI print. The peak CPI print of 9.1% was in general. June of 2022. That would put the timing of the average pivot up in stock starting around. Yes, you guessed it, January 2023, which happened, of course, spot on cue. Investors, the problem now is that, one, investor inflation expectations for a symmetrical drop in inflation that our team has discussed for 18 months have finally caught up to the reality. Two, inflation is seasonal, and it usually picks up in the first quarter. And three, inflation is set to run.

Starting point is 00:04:20 rise throughout the rest of January into February on the back of many of the exact same reasons for the repeat of the 1970s inflation hysteria zealots that they were talking about 18 months ago. Here are a few of the current reasons for a likely seasonal upturn in inflation. Yes, as we film, shipping rates have skyrocketed on the back of the Middle East Red Sea military exercises and low water levels in the Panama Canal. Second, energy prices are troughing, whether it's the cold weather here in the United States approaching up natural gas prices, higher the last two weeks, or the Middle East turmoil turning up the oil markets. Higher energy prices are bad for inflation data and bad for consumer sentiment.

Starting point is 00:05:01 Here's a chart of the real-time two-year break-even inflation rates. These are real-time. Investors, this isn't government data that takes months to compile and disseminate and it's revised many times. One can clearly see that historically, a lower trend in inflation is good. And a stable level of inflation is good. And a lower trend from a higher level is good. But a low level, trending higher is bad for the markets. Case and point from a recent example of the final point,

Starting point is 00:05:30 low inflation trending higher, we don't have to go back very far. In fact, we just have to go back to mid-January of 2003 through late February. Inflation expectations rose for about six weeks, and the cash S&P 500 dropped 300 points or about 9% from there. from 4195 to 3,800 in about six weeks, from early February through mid-March. Our team has highlighted that period in the S&P 500 chart. The second thing we've discussed multiple times over the last few years

Starting point is 00:06:00 that really matters to investors is real interest rates. Investors, remember that the Treasury yield, you get paid by the bank, is the nominal interest rate. It's the sum of the inflation component and the real yield premium, also called the Tips Yield. The real interest yield component of the Treasury goes a long way in determining the risk premium that investors are willing to pay for equities. When our Federal Reserve and other central banks around the world ran a world of zero and negative interest rates, this enabled and forced investors into a world of holding large equity positions

Starting point is 00:06:35 because money was essentially free. It created the notion of Tina, or there is no alternative. There's been a very strong and inverse correlation between the multiple on the S&P 500, investors are willing to pay in the direction of the two-year real interest rate. Here's an 18-month chart of the two-year real yield. It troughed in late November of 2021 and pivoted up as many Federal Reserve members began talking more hawkishly behind the scenes, even though Chairman Powell was out publicly still worrying about employment. The interest rate, of course, peaked in mid-October of 2003, just as virtually every strategist on TV, was out mirroring and messaging the

Starting point is 00:07:15 The Fed's phrase, higher for longer, and talking about academic nonsense around the theoretical R-star levels. This piece of data and this chart is almost entirely behind the November and December stock market rallies around the world. But you might ask, Chris, why aren't you more optimistic about the markets this year? Your team only has a target of 5,000 in the first half of 2024 for a target on the S&P 500. You might ask, why are you so cautious if lower trending real interest rates is generally good stocks and their multiples. It's the reason Tina existed for so long. That's what you told

Starting point is 00:07:49 us almost a year ago when almost everyone was negative, but your team was optimistic. Because history also says that there's a tipping point between positive investor sentiment and lower real interest rates as well. There's a point where lower real interest rates become a symptom of the economy that's not just slowing, but stalling and potentially heading into negative growth territory. And that's where investor optimism for the so-called soft landing, flips from hopeful and optimistic to worried, doubtful, and pessimistic. So what does this mean to you, the investor? Investors, this is a setup seasonally for higher trending inflation in the first quarter,

Starting point is 00:08:27 coupled with lower and falling real growth expectations that align with our team's messaging for the first half of 2024. Expect a period of higher volatility in the markets over the coming four to six weeks as other investors see these trends and start to worry about the outcome of a soft landing scenario. A completely normal outcome would be, at best, a continued stall for January and February in the overall markets, or more likely a sharp pullback post-January option expiration into month end February, much as what transpired in 2023. Whatever the case, the two things that have really mattered for your stock and bond portfolios, the last two years, are the same two things. And it's not time to get FOMO or fear of missing out as a better entry point in both price and time.

Starting point is 00:09:15 will likely show itself from lower levels in February. From the whole team here at Oak Harvest, have a blessed week and a fantastic new year. All content contained with an Oak Harvest podcast expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created, but any cited data, indicators, statistics, or other sources are not guaranteed. The views and opinions expressed herein may change without notice.

Starting point is 00:09:45 Strategies and ideas discussed may not be right for you, and nothing in this podcast should be considered as personalized investment, tax or legal advice, or an offer or solicitation to buy or sell securities. Indexes such as the S&P 500 are not available for direct investment, and your investment results may differ when compared to an index. Specific portfolio actions or strategies discussed will not apply to all client portfolios. Investing involves the risk of loss and past performance is not indicative of future results.

Stock Talk - Inflation, Real Interest Rates, and Market Turbulence: What Investors Need to Know

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