The Week Behind

Despite CPI falling below Fed Funds and PPI suggesting that CPI has further to fall, the stock market faced a challenging week as the debt ceiling, the Fed, and the regional banks brought recession into focus. Despite this, the NASDAQ managed to eke out a 0.40% gain thanks to continued momentum in big tech and AI, while the S&P 500 remained relatively stable. However, the Dow experienced a decline of 1.11%.

Highlights 

• No Fed tightening cycle has ever ended without Fed Funds rising above Headline CPI. With Fed Funds at 5.125% and April’s headline CPI of 4.9%, this marks the first time this cycle that criteria has been met, allowing a June pause to fit historical precedent.
• PPI, both core and headline, also fell short of expectations, suggesting that CPI could drop further in the following month.
• Initial Jobless Claims rose to 264K, reaching the highest point in 2023. The persistent increase in jobless claims suggests the economy may be slowing due to pressures from Fed tightening and regional bank stress.
• In his speech on Friday, St. Louis Fed President Bullard stated that ‘the prospects for continued disinflation are good but not guaranteed…’ In my opinion, this suggests that Bullard believes the Fed should pause and closely monitor economic data as the effects of monetary policy and regional bank unrest continue to weigh on the economy.

The Case for Cash

The inability of the S&P 500 to rally above 4200, despite two very benign inflation reports, leads me to believe that the debt ceiling and regional bank instability are capping the index’s upside.

History has shown that the debt ceiling can be an overwhelming bearish force, and there is no evidence to suggest that it has already been priced-in. If we were to see a repeat of the previous debt ceiling crisis, the S&P 500 could fall by as much as 16%, bottoming out at around 3465. 

At ~4125, there are 75 points to the upside and 660 points to the downside. With this risk-reward profile, it makes sense to start building a cash position to be ready in case of a potential drawdown. Personally, I have already taken profits on some of my core positions and closed out all but one of my trading positions. I’ve reinvested half of the total amount in 6-month U.S. Treasuries yielding 5.17%, which is the highest yield currently available, and have the rest available for opportunistic redeployment.

To be clear, I’m not predicting a 16% drawdown in the S&P 500. I’m being proactive and acknowledging the potential negative impact the debt ceiling could have on stock prices.

The Week Ahead

It is retail week: The most consequential economic retail report releases alongside a plethora of earnings that cover a broad spectrum of retailers. By Friday, we will know which product categories are strongest and weakest as well as have a better understanding of how consumers are responding as stimulus runs out and credit costs run up. 

On Tuesday morning, Retail Sales will provide a broad update on how consumers are spending in an environment without the benefit of stimulus and under pressure from increased credit costs catalyzed by the regional bank instability. The expectation is for a MoM 0.7% increase. A print above that would suggest consumers are spending more than anticipated, which bodes well for economic resilience and could create a powerful tailwind for consumer discretionary stocks. A below-consensus print would suggest the opposite; however, it would help build the case for a Fed pause. Ideally, we get a near-consensus number that does not scare consumer discretionary stockholders or move the needle for the Fed.

On the earnings front, Home Depot (HD) reports Tuesday morning. I expect HD to have a solid quarter and provide reassuring guidance due to the earnings commentary from homebuilders and the multi-month recovery in housing data. On Wednesday, Target (TGT) and TJX Companies (TJX) report. Inventory levels will be the story at TGT, while TJX’s results will provide insights into consumer trends in apparel. On Thursday, Walmart and Alibaba report. The former will provide a consumer spending mosaic for the U.S., while the latter will shed light on Chinese e-commerce.

Where I Was Wrong

A few weeks ago, I downgraded the regional banking scare to a regional banking situation. Although I never suggested investing in regional bank stock, recent developments have proven my assessment wrong.   

The trouble began with a bank run at Silicon Valley Bank, which forced management to observe a material loss on their bond portfolio that was underwater due to the Fed rapidly raising rates to fight inflation. With this in mind, I believed that if regulators could stop bank runs by convincing depositors their deposits were safe, the crisis would be over. I thought that the FDIC resolution for First Republic (FRC), in which all depositors were fully protected above the $250,000 limit, would restore that confidence. 

For a time, it did until messaging from regulators suggested they were detached from the reality of the situation. The Fed raised rates twice, compounding bond portfolio losses, and left the market with a laissez-faire commentary that implied there was no long-term solution in sight. The relaxed messaging from regulators, meant to set a calming tone to persuade the market it was ”business as usual“ for the regional banks, has been interpreted as regulators having a weaker grasp on the situation than believed prior. Justifiably, this put the market back on high alert and emboldened shorts to restart their regional bank siege, which makes it clear to me this situation is not as well handled as I previously thought. 

Otherwise, no brief next week. I will be on vacation in the mountains and away from the market action.