Weekly Review & Outlook: December 4, 2023

Additional October inflation data supported the earlier moderating inflation readings while PMI data suggest sluggish below long term trend economic growth. Consensus opinion that the Fed has reached its cycle terminal rate has firmed leading to strong market rallies in both Treasuries and equities.

S&P Global November PMI measures (November 24 & December 1) indicated the U.S. has entered a 2nd year of Manufacturing sector contraction while the Services sector expansion remains sluggish following a brief pickup earlier this year. October Personal Consumption Expenditures (PCE) data (November 30) showed continued moderation from the prior years’ inflation spike consistent with the earlier October Consumer Price Index (CPI) readings. 6-month annualized core PCE and core CPI have fallen to 2.6% and 3.2%, respectively. While both levels are still above the Fed’s 2% target rate, they demonstrate continued improvement and a substantial spread from the 5.5% target rate upper bound leaving monetary conditions “sufficiently restrictive” for the Fed’s price stability restoration efforts.

Confidence that the Fed has reached its cycle peak in the target rate led to a strong rally in November for both U.S. Treasuries and equity markets. The S&P 500 and Bank sector indices all experienced 2-sigma increases. Equity indices will now test their August highs for resistance. When near term volatility spikes, I frequently zoom out to orient position in the longer time frame context. Review of bank sector indices price performance from prior to the Great Financial Crisis through today shows charts that are essentially flat point to point over the nearly 18 year time frame. Despite the November surge higher in stock prices, the banking sector remains cheap based on longer run valuations.

Comparison between bank stocks and the broader equity markets finds a 35 percentage point spread in year to date performance. Review of the multi-decade, 1-year comparative returns between banks and the broader market, shows one of the most significant underperformance periods of the last 26 years. In 2 of the prior underperformance periods, the recovery and subsequent outperformance by the banks was relatively quick and sharp. Recovery following the GFC underperformance was long and mild.

The bank stock outlook for recovery today relative to the broader market will, in my opinion, most likely be sharp and quick. I write this based on the equity markets successfully shrugging off the impacts of restrictive monetary policy so far through the cycle. I think this leaves broad market valuations high with greater risk of longer run normalization. I also note that the negative earnings revisions for banks due to higher funding costs have mostly run their course. After the largest decrease for the 2024 EPS outlook occurring in the 2nd quarter, consensus earning profile for the sector has stabilized along with near term interest rates and funding costs.