MAGGIE LAKE: Hello, and welcome to the Real Vision Daily Briefing. It's Wednesday, July 13th, 2022. I'm Maggie Lake. And here with me today is Eric Johnston, senior managing director and head of equity derivatives and cross asset at Cantor Fitzgerald. Hi, Eric, great to have you back.
ERIC JOHNSTON: Maggie, how are you? Great to be here.
MAGGIE LAKE: I'm doing well. And we have a pretty action-packed day in terms of data, we had a hot consumer price inflation reading, I think everybody was waiting for that CPI. We had Beige Book Report. Interestingly, though, we didn't see that much reaction in the market. A little bit of push and pull, but no, outsize moves. I'm just curious what your take on that economic data was?
ERIC JOHNSTON: Sure. So, expectations heading into this print were that it was in all likelihood going to be a hot print. Straight for the overall numbers, looking for about 8.8%. But there was some analysts out there who were predicting 9%, and they typically have pretty good models. So, certainly an expectation was that this would be a poor number. And so, I think today, people may have come in and said market's down, either covering shorts, or saying, okay, if we can't go down on this number, then we're not going to go down. And it may be long for a trade or just, like I said, covering short.
To me, this was a very negative number, and not necessarily because of what it says for the actual inflation outlook, which there were some implications there. But I think more importantly, is that what it means for the Fed outlook. And so, the market is now pricing in today, essentially, that the Fed is going to pull forward the hikes. So, in all likelihood, the market's now pricing in 100 bps at the next meeting, and then the peak Fed funds rate being now end of this year.
And so, some could look at that based on that is more favorable for equities, where they want the hikes pulled forward, such that we can get it over with as a thought process, I guess. And as a result, the 2s 10s curve inverted significantly today. So, last time I checked, inverted by about 24 basis points, which is the biggest inversion since the year 2000. So, it's pretty significant. And we can discuss whether it is predictive at all, or not.
But you had that phenomenon. And then you had the expectations coming into today. But my view is just coming out of today that this is something that when you look at the CPI today, it was very broad. So, it wasn't just energy and food, you saw rents, which is rent is 33% of the CPI. And rents tend to be very sticky. And with 33% printing up mid-single digits year-over-year, that's unlikely to change anytime soon.
Yes, this may be a peak, but I think it's more going to act more closer to a plateau, where inflation stays very sticky in this 7% to 9%. area for the rest of least the next three or four months, which is going to prevent the Fed from pivoting.
MAGGIE LAKE: And that's contrary to what a lot of people are expecting. But your comment is really interesting about like the equity market thinking, alright, let's frontload this, let's get the pain over with. Watch what you wish for. Are they ready for something like that? Is the market priced appropriately for the scenario you just described?
ERIC JOHNSTON: I don't think it is. So, one of the thing people are looking forward to, oh, when the Fed pivots and then in 2023, the market's pricing in 75 basis points of rate cuts. And people are seeing that as a positive. But if you look back at all of the recent rate cut cycles, they have been coincident with sharp selloffs in equities, because the reason why the cuts are happening is because the world is in such poor shape.
And so, if you look at the last four or five rate cut cycles, they've all coincided with equities getting hit very hard. And so, my view is yes, they are pricing in 75 bps of cuts in 2023. But that's because this tightening that's going on right now and slowing growth is going to morph into a real big slowdown, a real big earnings, if you want to call it recession, which is going to then result in lower stock prices, and then ultimately potentially rate cuts, but that's not going to save the day.
I would also say that when the Fed eventually pauses on rate hikes, they're still going to be in all likelihood doing QT. So, this is also not a typical situation where the Fed is pausing, and then you have a clean slate. No, that's not the way that it's going to be. The other thing I would say is that there's a lot of talk about this pause. The Fed is going to have to be very, very sure that inflation is squashed. Because let's paint a picture where we are three or four months from now, and the CPI is running at 5%.
If they go ahead and verbally say in not so many words that we're done and taking a pause, and all of a sudden, all these risk assets, commodities, stocks rip, then you have the chance that inflation then reignites and so that's why I think it's going to be very-- I think the Fed's going to go longer than the market currently thinks, just for that reason.
MAGGIE LAKE: Yeah, that's an excellent, excellent point. And it almost seems like we went from talking about a Fed put to a Fed pivot, but people are expecting them to be the same thing, as you just described. Are people underestimating how much pain the Fed is willing to tolerate to get that inflation under control?
ERIC JOHNSTON: I think they are. And you've heard Powell say more recently that in all likelihood, this is going to cause pain. And that's somewhat new for him to say that. I think people are also-- my view is you have to listen to the Fed. And whether you think that they are right, wrong, making his mistake, doing great, you have to listen to the Fed. And that's something that we did on the way up.
So, coming back half of 2020 and 2021 when we were incredibly bullish here, our reasoning was the economy is growing and sharply, we have all this pent-up demand, and the Fed is easing. And they're telling you that they're not going to stop easing. So, you follow the Fed. Now, the Fed is telling you that they're not worried about, essentially, about recession, we are worried about inflation, and we are going to be proactively until we see inflation come down sharply and hit our target of 2%, we are going to be on it.
And they made a very important point. Because everyone talks about their dual mandate being employment and inflation, but it doesn't mean employment necessarily today. And so, what they said, and this was very important, they said that we're looking at what is best for employment long term. So, they can make the argument that although this is hurting employment today, that for the long-term betterment of the employment picture, we need to squash inflation. They've said that, and I think that's what they're going to do and that is not friendly for equity prices, and risk assets in general.
MAGGIE LAKE: And you shared a chart with us. I think there's also this perception the Fed's late to the game, all that easy policy is still fueling all of this runaway inflation. But you sent over, and a lot of people have been talking about the rapid tightening of financial conditions, are we not paying enough attention to that? Is that something that we're not seeing? Because it's not tangible right now?
ERIC JOHNSTON: That's right. If you look at the financial conditions on a monthly basis, two of the four largest tightening of financial conditions, I believe, in the last 20 years have occurred in the last four months. So, the rapid tightening is something that is highly unusual. And we are starting to see in a big way, the impact of that. And you can really see it across the board, whether it be the economic numbers, new orders to inventories, is that x COVID? Is that a 10-year low?
All the regional surveys. You look at the small business optimism index, which came out this morning, that is hitting nine-year lows, consumer confidence, all-time lows. And then you're seeing it from corporates. How many corporates recently have announced either job slowing or job cuts. That is a very new phenomenon within the last three, four months. And then you have real time information coming from corporates around Restoration Hardware, Micron, Nike, where revenue estimates or even in inflationary environment are getting caught.
So, we're seeing the impact of these tighter conditions real time. I think in terms of today, one of the things, CPI was the dominant story. But I think what was very important also was the Delta and Fastenal earnings, because Fastenal is considered an early cycle industrial. And what they said was that May and June, they started to see the impact of these tightening conditions and the impact of the slower economy hitting their business. And they also lowered margin estimates for the second half of the year.
And then the other one was delta. So, delta had close to record revenues, which makes sense, and people think about equities and people say, okay, well, that's an inflation hedge. Well, equities are not based on revenues, equities are valued ultimately on earnings. And so, delta had close to record revenue, but their earnings got hit, and was well off the highs because of higher costs. And I think this is going to be a theme for earnings season as we go forward.
MAGGIE LAKE: Yeah, we have the banks coming up next, and then they're really going to start coming in fast and furious. Have those expectations come down, though, Eric? Because I feel like even just a couple of weeks ago, people were scratching their heads and saying there's some reason to be concerned, especially if you look at the dollar, but we're not really seeing some of those earnings estimates come in. So, is maybe the economy stronger than we think? Or is the economy stronger than we think? Or is the street just behind on that?
ERIC JOHNSTON: I think the street is just behind on that. We've been conditioned that corporates always beat earnings estimates. They lower the bar, and then they beat, and stocks do well during earnings season. But also, we haven't had the slowdown that we've just seen in a very long time. And so, number one is I don't think that earnings estimate cuts are priced into stock prices.
The two worst performers today in the S&P 500, delta advance at all. And then I would just say that not only is it not priced in, but as you pointed out, earnings estimates have not moved at all. And so, if you look at earnings estimates today versus where they were four months ago, they're about unchanged from where they were, and what's happened in the last four months, the dollar has absolutely screened higher. You've seen the economic data sharply slow.
You've seen a number of consumer companies talk about that slowing, debit card transactions have started to slow. So, for that not to be changed to me is just people being complacent, looking at the past and just saying, okay, corporates will do it, they'll come through again, and I just don't think that's going to happen. And the chart that you have up there around earnings estimates shows the parabolic rise that we've seen in earnings, and it's all well, well above trend.
Operating margins are well above trend, return on equity are well above trend, essentially, companies have overearned post COVID as there was pull forward effect, rising inflation, which actually has helped corporates over the last year. And so, I think that now is the time where margins are going to finally come down and it's going to be a very challenging time for corporates, and it's not priced in.
MAGGIE LAKE: So, how much of a risk mispricing are we looking at equities? How much further do they need to come down to adequately reflect rather the environment that you're suggesting?
ERIC JOHNSTON: So, typically least of late, of late meaning the last few recessions that we've seen, earnings have come down between 15%, it's been a wide range but have come down between 15% and 35%. This time, the recession is likely to be more shallow than some of the prior recent recessions. But at the same time, the starting point for earnings is also more elevated going back to the point about overearning.
So, right now the estimate for 2022 is 228. It's a bottoms-up estimate. The estimate for 2023 is in the 250 area. I think next year, or excuse me, the next maybe call it 12 months for them to come in at somewhere in the 205, 210 area, which you're talking about a 10% cut to earnings, I think is the minimum that we're going to see. And I also think that that is plenty enough to get stock prices down, because not only will you have the E coming down, but I think the market will put a lower multiple on the lower earnings, because the market won't know where the bottom is in the E.
And that's typically what you see, you saw it with Target, they missed numbers, their multiple actually comes down to lower numbers. And then the other trend that we see is once someone cuts once, they almost always cut a second time and usually, a third time. And so, that'll be the expectation is that these first cuts, will be the beginning, not the end.
MAGGIE LAKE: So, what are we looking at for the S&P 500 in that scenario? Do you have a downside target on that?
ERIC JOHNSTON: So, right now, I'm targeting the low 3000s for the S&P to have that exact-- what the exact number is is very hard to say, but I think a 20% haircut if from here, I think is real. And so, the low 3000 area. I think one of the things that in some of the data that we've run, which is actually in the presentation that will be supplied here is that when the market sells off more than 23%, at the lows, we were down about 24%, the likelihood that you sell off in additional 20%, 25% goes up dramatically versus normal times.
So, at any given benign time, to think that we're going to sell off 25% is very unusual. But the last seven times that we've since 1970, that we've sold off more than 23%, the market has gone on to sell off an additional 25% plus in three of those seven times. And we had about a 15% selloff in the fourth time. So, the odds, the risks go up dramatically once you had this type of selloff already.
MAGGIE LAKE: I think that's so important, because so many of us have been conditioned to look for the dip, to look for the bottom, to want to try to buy and when you see stocks off their highs that much, we get that question a lot. We have some questions coming in. And I was thinking this as well, why haven't we heard companies-- so, analysts notoriously tend to be biased bullish and a lot of times late on this to be fair, but why haven't we heard companies warning about earnings? Mark from the RV site is asking about that.
ERIC JOHNSTON: I think it's a great question. And one of the things that I thought was a potential risk for the first two weeks of July was some negative pre-announcements, which we really haven't gotten. And I think the reason is, is because a bulk of the cut to numbers is going to come from guidance. And so, if you're a company, you just completed your quarter, and you're sitting here and you're likely going to make the second quarter, but you're going to lower guidance, you're not going to pre-announce that. You're only going to pre-announce if you're going to have a significant hit to second quarter numbers.
And so, I think that's really the reason why we're getting announcements like we got last night where Google puts out an email to their employees saying we're going to be slowing down hiring. So, I look at something like that, and they must be seeing something in their business in order to initiate that email to their employees. And so, there's a lot of signs like that that suggest cuts are coming, but it's most likely going to be in guidance as opposed to Q2 earnings.
MAGGIE LAKE: That is a great, great explanation. And it makes a lot of sense. And it I think speaks to this fast and rapid decline that some people are worried about happening in economic conditions, because of that financial tightening you talked about and some of the pressures coming on earnings from both input costs and a strong dollar and such. I want to plug in another piece of this, and then I'm going to get to some of the questions.
By the way, we're going to put all of Eric's charts up on the site so you can look through them in more detail and really expand them. And if you're on the site now, go ahead. And if you want to pull any of them up, you could see it in real time. But the other piece of this is also commodities. And we've seen them coming off and it's been a really difficult time.
For some people, that's also concerning. It's a little confusing, because inflation is still running so hot, but in the ag commodity space where there was a lot of a big quick run up, we've seen a rapid decline in some of them, I had the opportunity to sit down with Shawn Hackett, he specializes in agricultural commodities and looking at the impact of weather. Some of it is longer term, but some of it is also near term as well as he tries to sort out cross asset impact on agriculture. And he's also concerned about the future and particularly that this is not the time when you could just broadly make a bet, let's listen to what he had to say.
SHAWN HACKETT: For the next 12 months, meaning from now to next summer, early fall, I think you really got to pick and choose, it's going to be a commodity pick. I don't think you're going to do well with a broad basket of commodities like you did from 2020, 2022. Now, when we get to the latter part of 2023, and we get into that 2024-2025 Gleissberg cycle, then I think you can be more broad again, and I think that could work.
But I think you need to shift gears to being a commodity picker in the next [?], it's not a just on a mall kind of thing. I really think that's a great question. And I think it's really is a different strategy the next 12 months than it's been for the last two years, quite frankly.
MAGGIE LAKE: And that full interview available to all subscribers on the website. And if you're in that space, you'll definitely want to check it out. Shawn talking about a one