​What were the odds the Federal Reserve could raise rates dramatically, reduce inflation, minimize job losses, AND preserve overall demand? 
 
Low to none.
 
However, the data suggests that the odds of success are rising dramatically.  Demand is resilient, wages are falling, inflation is falling faster, and jobs are STILL plentiful. 
 
We are in Goldilocks.  Goldilocks is an economic environment where both demand and supply are in balance.  Not too hot, not too cold.  Goldilocks is important because the Fed now believes it has regained control of inflation, and it can slowly pivot to re-focusing on preserving demand.
 
Is Goldilocks temporary?  The economic pessimist would point to 1) interest rate increases have a lagged effect and 2) the negative impact on the economy will be evident in the 2nd half of 2023.

​The leading indicators are pointing to a slowing economy.  Large rate increases make the slowdown unavoidable.  However, as inflation slows, the odds of a less severe slowdown are rising dramatically.

Chart 1: Growth In Restaurant Sales

​Growth is resilient, so far
Most macroeconomists look at GDP projections to understand growth.  While GDP is growing, and growing faster than most estimates, investors should look at more meaningful measures.  One such measure is overall eating out sales.  When consumers are unsure about the future, one of the first places where we cut back is eating out.  Eating at home is cheaper.  As chart 1 indicates, restaurant sales growth over the past six months is unchanged.  When the outlook becomes uncertain, restaurant sales will be the first to signal change.  

Chart 2: Atlanta Fed Sticky CPI ex rent at 2% (3 month annualized)

​Inflation is falling
Inflation was clearly a problem.  The global economy encountered a once-in-lifetime demand and supply shock – at the same time.  However, that is in the past.  The money that was pumped into the system has made its way in, and out.  Demand is back to normal.  The supply shock from a total shutdown and reopening is also behind.  Therefore, inflation is falling and falling faster than most are willing to believe.  The leading indicator for inflation is the Atlanta Fed sticky CPI excluding rent.  The latest reading shows CPI down from 8% to 2%.  The Fed believes 2% is the ideal level for inflation.  More details on inflation are here.

Chart 3: Unemployment Claims (blue) and Job Openings (white)

Despite rising layoffs, employment is steady
Corporations right-size their cost structure when they expect future profits to be lower.  One way to right size is to reduce the number of employees.  Not a day goes by without reading layoff announcements by major corporations. 
 
Despite rising layoffs, unemployment claims (blue line) - a leading indicator that signals a rise in unemployment - are at record lows.  Therefore, laid-off employees are finding new jobs rather easily.  New job openings (white line) are close to all-time highs.  While most leading economic indicators are at recessionary levels, employment claims are the key measure.  A low level of claims indicates employment is not an issue, so far.
 
The economic silver lining in rising layoffs – if there is such a thing – is layoffs are reducing the pressure on wages increases.  This is the Fed's goal!

Chart 4:  Wages (yellow) are rising faster than inflation (red) 

​Net savings deficit to surplus
Consumer spending drives the economy.  For this engine to keep moving, jobs must be plentiful, and incomes must grow more than expenses.  In 1Q22, inflation was rising faster than wages (red arrow), which was a headwind for savings and spending.  However, that has reversed.  Wages are now growing at a faster rate than expenses (green arrow) which creates consumer surplus.
 
The Fed's goal is to reduce inflation by cooling wage growth, without causing large job losses.  As unlikely as this may have been last year, demand is resilient, wages are falling, unemployment claims are falling, and inflation is falling faster.  This is GOLDILOCKS.
 
The probability is rising that the Fed is less foe and more friend in 2H23.  Markets are rallying in response to goldilocks.  The sustainability of goldilocks is a question that only time can answer.  Until then, enjoy it.

--
This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund").  Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law.  An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal.  There is no secondary market for interests in the Fund and none is expected to develop.  No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.

This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund.  These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described.  These forward-looking statements will not be updated in future. ​

A Price-Earnings ratio (P/E) is a shortcut.  It has two simple inputs: 1) Price and 2) Earnings.
 
​Can valuing a market, or a stock be that simple?  No.  Markets are complex.  Read on.
 
While the price and underlying earnings are important, understanding the context is paramount.  Movement in interest rates, understanding of economic cycles and earnings, prevailing investor sentiment, and sector composition are important inputs into building the context. 
 
However, interest rates are the lynchpin.  Let’s start there….

Chart 1: S&P P/E and Interest Rates

​Source – Yardeni.com
 
Interest Rates: The P/E ratio is inversely proportional to interest rates.  The present value of future cash flows changes, as interest rates change.  For this discussion, let’s use the 10-year treasury yield (red line) in chart 1 as the interest rate.  Therefore, when interest rates are high - the P/E ratio is low - and vice versa.  In the 1970s when inflation and interest rates were bordering on double digits, the P/E ratio was close to 10.  Despite the low P/E, markets were flat for a decade in the '70s, because rates kept rising.  During 2015-20, inflation was non-existent and interest rates globally were low.  In Europe, interest rates were negative.  It should come as no surprise, the P/E ratio was close to 20.  Despite the high P/E, markets did well because rates fell.  Therefore, it is important to understand the P/E ratio in the context of 1) where interest rates are in the present relative to history, and 2) where they may be going.

Chart 2 - S&P and Earnings Growth​

Source – Ned Davis Research

Economic Cycles and Change in Earnings:  As earnings growth accelerates, the P/E ratio expands.  The acceleration gives investors a higher degree of certainty about the future.  Therefore, investors pay up, which is reflected in a higher P/E.  Typically, earnings rise for several years after a recession.  Therefore, the P/E expands (grows) at the depth of a recession in anticipation of a new economic cycle.  The reverse is also true.  As earning growth decelerates after a long economic expansion, the P/E ratio contracts as the likelihood of bad economic outcomes rise.

Chart 3 – S&P vs S&P Earnings

Source – Canaccord Genuity, Ned Davis Research
 
Investor Sentiment:  There are three unique periods in recent history when investor sentiment played a large role in valuation.  1995-00 was a period of euphoria.  Investors believed the internet was transformational and therefore, no price was high enough.  This ended with the Dot Com crash.  On the contrary, the 2001-04 period was an outlier with low valuation despite good earnings growth for two reasons: 1) 9/11 created societal uncertainty, and 2) major corporations (Enron, WorldCom, and Tyco) were embroiled in accounting scandals and corporate dishonesty.  Investor belief in the system eroded.  Similarly, 2009-2013 was an aberration for P/E ratios.  Despite solid earnings growth and historically low-interest rates, the P/E ratio was historically low.  The global economy was recovering from the Great Financial Crisis.  Investors lacked confidence in future growth, which was reflected in a low P/E.
 
Chart 4 – Historical S&P Sector Composition

Source – DWS Investment Management

The Composition of the market:  Sector weights ebb and flow and impact the overall P/E.  Like in 2000, technology was the largest component of the market in 2021 (chart 4).  Cyclical sectors such as Energy, Industrials, and Materials were at historical lows.  In 2006, it was the opposite.  Energy, Industrials, Materials, and Financials had a significantly larger weighting in the S&P. 
 
Cyclical sectors have a lower P/E ratio.  Simply, they are cyclical, and investors pay less for future earnings due to higher uncertainty.  Therefore, comparing the S&P P/E across history without normalizing sector weights is a mistake.  It's comparing apples to oranges. 
 
Chart 5 – Change in S&P Forward P/E

​Source – Alpine Macro
 
Changes In P/E:  In 2022, as rates catapulted from 1% to 4.5%, the S&P P/E ratio had one of the most significant declines in modern history (chart 5).  The only historical period in the past 40 years when the drop was more severe was the crash of 1987.  The shaded bars in chart 4 are recessions.  Outside major disruptive events, after a large fall, the P/E rises.  This historical context challenges the current consensus thinking that P/E will drop further as earnings continue to decrease.  Therefore, if inflation collapses in 2023, will P/E rise rapidly?
 
The P/E ratio is a simple shortcut.  However, markets are complex.  When it comes to P/E, don’t keep it simple.   

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This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund").  Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law.  An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal.  There is no secondary market for interests in the Fund and none is expected to develop.  No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.

This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund.  These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described.  These forward-looking statements will not be updated in future. 

Inflation is falling and falling faster than most are willing to believe.
 
The current inflation reading is 6.6%.  As citizens, we know that current inflation is still too high.  As investors, we are focused on the rate of change in inflation over the next six months.  Not where it is today.  Not where it was in the past.
 
Let’s focus on forward looking metrics.
 
One forward looking measurement is the quarter-over-quarter annualized inflation.  Instead of year-over-year, we measure the quarter-over-quarter increase, and we multiply it by 4 to get an annual number.  Based on the Cleveland Fed data below, CPI is already at 3.1%, while other measures are rapidly falling below 5%.
 
Chart 1 – Quarter over Quarter Annualized Inflation
​

Source – Cleveland Federal Reserve
 
What about sticky Rent inflation?
 
While rent inflation is high and sticky, it has a substantial lag.  Remember, as investors we want to be forward looking.  Most market-based rent metrics are showing a rapid decline in actual rents.  Even Fed Chair Jay Powell admitted to the lagging effect of rent inflation and is focused on real time data.  Therefore, instead of 8% reading in the most recent report, the real-time reading is closer to 4% as shown in the chart 2.
 
Chart 2 – Actual Rent Inflation and New Tenant Rent Estimat

Source – Guggenheim Investments
 
Sticky CPI ex rent at 2%
 A three-month annualized estimate is the leading-edge inflation estimate.  To calculate this estimate, we look at month-over-month inflation for the past three months and multiply it by 4 for an annual number. 
 
Atlanta Fed Sticky CPI is a weighed basket of items that change prices relatively slowly.  However – sticky CPI excluding rent (we know rent lags) – is almost at 2%.  See chart 3.
 
Chart 3 – Atlanta Fed Sticky CPI (white) and Sticky CPI ex rent (blue)

Source – Bloomberg
​
CPI Projections
 
The Fed missed the inflation call in 2021.  To ensure that inflation isn’t entrenched, Chair Powell is willing to keep rates high until inflation gets closer to the 2% mandate. 
 
In December, month-over-month CPI decreased by -0.1%.  If we were to keep that constant, year-over-year inflation will reach the Feds goal of 2% by April 2023.  If we assume a month over month growth of 0.2% for the sake of conservatism, CPI will be under 2% by June of 2023.   I’ll let you make your own assumptions.
 
Chart 4 - Projections for CP

Source – Bespoke Research
 
What does this mean for interest rates?
 
Fed has a dual mandate: 1) inflation and 2) employment.  Employment is still very strong because jobs are easy to get.  Therefore, the Fed is laser focused on inflation.  Historically, once the Fed funds rate moves above year-over-year CPI, the Fed knows they are fully in control.  While we aren’t there yet (chart 5), based on the projections in chart 4, we know Fed will be well in control starting March 2023.
 
Chart 5 – Fed Funds Rate and CPI

Source – Federal Reserve of St Louis
 
What Are the Risks?
While positive for growth, the base case impact of China reopening and stimulative policy is for the dollar to weaken, and for commodities to rise.  This could reverse some components of declining inflation.
 
Goods prices have collapsed over the past year.  They will not keep falling at the same rate.    They may even rise and offset the deflationary impact in other areas. 
 
Are We There Yet?  What does it mean for the Fed?
 
If history was a guide, the Fed would already be cutting interest rates.  However, a once in a century pandemic and stimulus has changed the current calculus.  Fed is more focused on inflation, and less on growth.  Given the rapidly declining inflation, we are likely in the 9th inning of this rate increase cycle. 
 
The aftereffects of interest rate increases are felt with a lag.  While job layoff announcements have risen, jobs are still easy to find.  Starting in 2Q, unemployment claims will increase.  With inflation well under control, Fed will likely focus on employment, its other mandate.  The first step will be to announce a pause in rate hikes.  Usually, rate cuts follow in six months.  Post WW2, Fed has cut interest rates by 3% after a pause, and to a larger extent in the past two decades.
 
Chart 6 – Historical Rate Cuts

Source – Fidelity
 
What does this mean for the market?  Stay tuned.


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This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund").  Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law.  An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal.  There is no secondary market for interests in the Fund and none is expected to develop.  No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.

This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund.  These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described.  These forward-looking statements will not be updated in future. ​

What differentiates a bear market rally from a durable market advance?

Earnings, or fundamental do not make that list.  They deteriorate well after the market bottoms.

The answer is rate market breadth metrics.  Here are a few that have raised the probability that the market is in the early innings of a durable market advance.  

​1)  When the % of S&P stocks above 50 day moving average moves from <= 15% to >= 90% within 50 days, forward 12 month returns are above average

Source - Mark Ungewitter @mark_ungewitter

3) When S&P 500 has a 4 week win streak and gained 10% or more while below the all-time high weekly close, forward gains were positive in each case over next 12 weeks

Source - Steve Deppe

​4) ​When the S&P 500 gains 10%+ over 2 months with negative training 6 month returns, the forward 6 and 12 month returns are strong

Source - Steve Deppe

5) When the % of stocks above their 50 day moving average crossed 55%, forward returns were positive

Here are 5 charts that suggest that inflation has peaked and on its way to moderating over the coming 12 months

1) Record high retail inventories (look out for sales)

Source: Bloomberg

2) Decline in prices paid for manufactured goods

Source: Bloomberg

3) Decline in prices paid for services

Source: Bloomberg

4) Reduction in supply chain bottlenecks

Source: Bloomberg

5) Decline in commodity prices

For context, here is the original Recession Framework essay LINK .
​
Here is my recession framework that has proven the test of time.  It has identified every recession Post World War II.  There are four key criteria.  Think of this as a dashboard with green, yellow, or red lights.  If the dashboard is mostly green - sprinkled with a few yellows - we are safe.  As the count of yellow and red lights rises, so does the risk of a recession.  Similarly - reds turning to yellows is a sign of optimism -that the worst may be behind us.  

Remember, this is a dimmer, not an on/off switch.  

1)  Is the Leading Economic Indicator (LEI) gauge falling sharply and close to Zero? YES
The LEI is a comprehensive forward looking metric that accounts for manufacturing new orders, building permits, change in hours worked, credit issuance, interest rates, stocks prices etc.  As you can see above, when the LEI falls sharply and turns negative, a recession follows.  Today, the LEI is falling sharply again, and close to turning negative.  Manufacturing new orders and hours worked[1] in the ISM surveys are already contracting. 

Today, this is a yellow, but turns to a red once it falls below zero.

​2)  Has the yield curve inverted?  Yes
When long term rates are below short-term rates, lending is unprofitable.  So, banks stop lending.  New businesses cannot get off the ground and existing businesses cannot expand.  This slows new economic activity.  The 10 year rate is now firmly below the 2 year rate for several weeks, or inverted, in investment terminology.  This is flashing red.  As you can see in the chart above, a recession follows within 6 – 12 months of yield curve inversion.

3)  Are credit spreads widening significantly? Almost
When junk bond yields move significantly compared to (safe) treasury yields, it is a major warning.  Investors are selling risky investments and buying safe ones.  They are demanding a significant premium to compensate for the rising risk.  Indicated by the red arrows above, at least a deep market sell-off, if not a recession follows.  Today, credit spreads are moving higher, warning of potential trouble ahead, but not at recession levels.

Today, this is a yellow, but close to turning red.

4)  Are unemployment claims rising sharply?  Almost
When a business lays off an employee, that layoff is reported to the government and is captured as an unemployment claim.  To avoid false signals, we need claims to rise sharply.  This triggers a warning sign for the labor market.  70% of U.S. GDP depends on consumer spending, and consumers don’t spend when they are fearful of layoffs.  As the red arrows (long term chart above) indicate, recession follow sharp and sustained spikes in claims.  Over the past four months, claims have risen more than 25% (see below).  A further rise would make a recession official.  

The recession dashboard has 1 red and three yellow lights.  The deterioration since March speaks for itself.  The yellows and red indicate we are on the cusp of a recession.  

(1) Employment in the manufacturing survey has contracted for May and June and June only for services (number below 50 indicates contraction)

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​This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund").  Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law.  An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal.  There is no secondary market for interests in the Fund and none is expected to develop.  No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.

This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund.  These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described.  These forward-looking statements will not be updated in future. ​

​Like any economy, the markets also go thru cycles.  These cycles are a byproduct of three larger cycles: 1) Demographics, 2) Business and 3) Central Banks.  When these three are in unison, markets advance like speed boats.  The fantastic returns from 2020-21 are a perfect illustration.  So is the period from the late ’90s.  However, when they work as a tandem in reverse, they produce the lost decade of 2000-09.  Let’s dive into the specifics of each cycle and how it works.

Let's Talk Demographics.

Source – Ned Davis Research
Our economy grows when we collectively spend more.  However, only structural factors can drive aggregate spending over a long period.  A demographically driven growth spurt is one of those structural reasons.  Simply, when a couple gets married and is close to having a baby, they buy a house.  They buy a larger car.  The household spends more.  Down the road, they have another baby.  They buy an SUV or a minivan and move to the suburbs!  They are motivated to earn more because they spend more.  When a large population cohort enters this life stage – think Baby Boomers in the late 70s and early 80s – it unleashes earning potential for businesses and opportunities for entrepreneurs.  A rising tide lifts all boats.  Demographic forces are measured in decades and provide structural tailwinds for markets over a long duration.  Look at the chart above to understand the power of demographic inflections.  The opposite creates a strong undertow that produces immense drag.  The lost decade wasn’t an anomaly.  Today, we are in the early innings of another structural acceleration.  Millions of Millennials are entering a household formation phase, leading to another demographic inflection.  What took place in the early ’80s is repeating again, today! 
 
What is a business cycle?

Source - OSAM
A business cycle is simply a boom-bust cycle measured over several years.  An event creates a disruption for business.  To conserve cash flows, businesses reduce investments, inventories, and lay off employees.  Consumers react and reduce their own spending.  This virtuous cycle turns into a recession.  Over time, as the impact wanes and spending troughs, consumers stop being scared and cautious.  We start to spend again.  Businesses gain the confidence that the economy has cyclically turned for the better, hire employees, and invest in plants and inventories.  This leads to more hiring, more investments, and more consumer spending.  The anguish from the ‘event’ fades into distant memory.  Animal spirits return … just in time for another ‘event’ to sap our collective enthusiasm.  We rinse and repeat.  Business cycles, or boom-bust cycles, occur even in the context of a larger demographic cycle.

​Central Bank cycle

Source – Ned Davis Research
The last, and arguably the most dramatic, is the Central Bank Cycle.  Whether right or wrong, our Central bank, a.k.a The Fed has a two-pronged mandate; 1) maximize employment and 2) avoid extended bouts of high inflation.  The Fed swoops in during a bust to protect the economy and jobs by reducing interest rates and by supplying excess money.  In theory, this makes sense.  This alternative money acts countercyclically when consumers and businesses are retrenching.  This is how we get over the ‘event’.  When the business cycle gains momentum again, the Fed removes its monetary help, hoping the businesses can be self-sustaining.  However, if inflation rises too quickly, the Fed steps in.  They tap the economic brakes.  Reduced demand and business activity help to cool inflation.  Although, the Fed’s track record is poor.  Business cycles don’t generally end.  The Fed ‘kills’ them by going too far.  Look at the illustration above to see how markets follow Fed movements.
 
A Powerful Combo
To add context around these three cycles, think of ‘Covid’ as the event.  Covid was the catalyst for ending the previous business cycle.  Central banks around the world started a new cycle by pumping massive amounts of money.  Covid accelerated a ‘Millennial demographic cycle’.  Young city dwellers moved to the suburbs in droves in search of extra living space.  Babies and minivans come next!  A new business cycle was born.  Businesses flipped from layoffs to hiring.  Most of the jobs lost were recovered.  This cycle is also atypical.  What takes several years was accomplished in several months.  The S&P rose 115% from March 2020 to December 2021.  Now inflation is very high.  The Fed support is at its apex.  The business cycle could also be at its apex.  Well, guess what, we have another ‘event’.  Could the collateral damage from a war trigger another bust?  Only time will tell. 

History doesn’t repeat itself; humans do – A Wise Man
While the ‘event’ is always different, and extenuating circumstances vary, the chronology of boom-bust cycles is always the same.  A wise man once said, “history doesn’t repeat itself, humans do.”  Consumers and businesses act predictably to every boom and bust.  However, the bust period is shorter and shallower if it happens in the context of a longer and more powerful demographic cycle. 
​
Let’s go back to J.P.Morgan’s answer, “it will fluctuate, young man, it will fluctuate.”  Markets do fluctuate short term.  A hundred years of history also suggests that markets cruise long term.  However, most investors miss out because they get greedy at peaks and fearful at troughs.  At Latticework, we map the inner workings of cycles and the businesses they impact.  We use this compass to deconstruct why markets do what they do and navigate the fluctuations.  We can help, especially when the seas are rough.  Reach out to us. 

​Late last year, there were multiple data points screaming that inflation was rising at an alarming rate, labor markets were very strong, and interest rates were in record negative territory. Therefore, the Fed was extremely behind in normalizing policy.  One need not be a ‘Macro investor’ to come to this simple conclusion.  The payoff to protect portfolios was asymmetric and in favor of one who has the courage to go against this trend.   When I wrote this note (LINK) most of the replies that I received were that inflation was ‘transitory’.  After two consecutive prints of CPI > 7%, that narrative has flipped on its head.  

​

Source - Bloomberg

​​However, over the past month, most investors and economists are now racing to beat each other in predicting record rate hikes.  As of today February 17th, markets are expecting a half percentage point rate hike in March and 7 hikes over the course of the next twelve months.  Most now have a view - whether the Fed will hike slower than - or faster than the market expectation.
 
As investors, Game Selection is a critical choice.  What area can one spend their precious resource – time – and expect a differentiated insight from the rest of the market?  For most, individual securities may be a good game.  For others it may be macro forecasting.  However, when it comes to the Fed, the base rate for successful prediction is abysmal for multiple reasons:

1. Economic future is hard to predict
2. The Fed board itself does not know their actions
3. Investors cannot forecast changing trends

​Source – Roberto Perli, Piper Sandler
 
As correctly pointed by out by economist Roberto Perli in the chart on the right, most historical predictions on future Fed policy have been wildly incorrect.   The lighter lines above represent market expectations for Fed Funds rates as of Mid-February of that year.  As you can tell, the forecasts are spectacularly wrong.  The lighter lines on the left chart are projections of the Fed itself about future rate hikes, and they are generally wrong also.
 
Here is the punch line, select a game only when the odds of winning are high.  When it comes to future rate increases, we are all speculating.  So is the Fed.