2023 Endless Dilemma: Is the US stock market stagnating, experiencing severe or mild decline, or experiencing slight growth?

After a fierce and muddy 2022, the start of 2023 can be said to be full of joy. However, this "joy" came unexpectedly for many people. They didn't even have time to react before the car started running, leaving them only with regrets and frustration.

Currently, the U.S. earnings season is coming to an end. Based on the observations and insights made at the macro and micro levels of various companies during this earnings season, along with the continuous macroeconomic tracking conducted by the Dolphin Analyst, this analysis attempts to comprehend the deviations between market trading and expectations, estimate potential future scenarios, and provide possible response strategies.

Here are the key conclusions of this analysis:

1) After the epidemic, the shortage of labor supply due to structural reasons, coupled with the demand for jobs (restaurants + medicine) that is not sensitive to interest rates, has resulted in the job market demonstrating strong resistance to interest rate strikes during this cycle. After reducing transfer payments, this means that residents' income-generated consumption remains resilient.

2）After the helicopter money provided during the epidemic, the American economy, which is essentially driven by domestic demand, has seen the risks of residents' balance sheets being taken on by the government, and since the end of the fourth quarter of the last fiscal year, this risk has only improved. Even with rising interest rates, the risks associated with the residents' balance sheets are not significant as long as they do not incur further debt for consumption. The main risk to the federal government is currently reflected in the debt limit.

3) The American economy is a typical example of a domestic demand-driven model. If the risk of residents' balance sheets is not significant and the growth of residents' incomes is slow, in the four broad scenarios of "stagflation, mild recession, deep recession, and mild growth," the probability of future transactions being mildly growth-oriented or slightly recessionary is further increased. This means that the overall likelihood of the U.S. stock market fluctuating upwards is greater than the likelihood of it fluctuating downwards.

4) However, note that under the expectation of mild growth, the U.S. dollar may be relatively strong, and currently, the pricing of the RMB's appreciation during trading in the Hong Kong stock market is repeated, meaning that the fall in RMB could lead to a decline in the Hong Kong stock market.

5) Under these macro expectations, when it comes to stock selection, investors should look for companies that still maintain their competitive position and market status. Investors should look for opportunities from two major areas: high prosperity (such as Airbnb) and cyclical reversals (such as Amazon).

The Dolphin Analyst will continue to release U.S. industry strategies and individual stock judgments in the near future. Stay tuned.

The following is the main content:

1. Reflection on the beginning of the year: What did we miss?

After returning from the Spring Festival holidays, in the opinion of the Dolphin Analyst, there were mainly two trading directions and expectations for the market:

There will be a certain recession in the United States in 2023. Even if inflation and valuation are repaired, and the earnings-per-share (EPS) collapse causes the stock price to collapse, China's economic recovery will support Hong Kong stocks. Correspondingly, investors should long Hong Kong stocks and short U.S. stocks, at least believing that the relative return of Hong Kong stocks will significantly exceed that of U.S. stocks;
It is best to avoid big positions during the U.S. earnings season in the fourth quarter.

However, the actual trading results are:

First of all, the earnings reports don't really matter, as even if the results are bad, some stocks are not falling and are even crazily rising. As long as the performance is slightly better, the stocks are mainly rising.
Secondly, in terms of cross-market strategies, U.S. stocks, especially Nasdaq, clearly outperform the rest of the world, while Hong Kong stocks, which were a popular choice before the Lunar New Year, turned out to be the worst performers.

Those who closely follow Dolphin Analyst's weekly strategy report may notice that with regard to the turning point of risks and opportunities in US stocks, Dolphin Analyst has already made a prompt in "Hong Kong and A shares have changed places in terms of cost-effectiveness , how far is the changing situation of "risk" and "opportunity" in US stocks?".

"In this case, it is worth paying attention in advance to some undervalued stocks that are sensitive to changes in interest rates but have a relatively stable industry status, such as some semiconductor leaders in US stocks, such as Qualcomm, and some Internet technology companies like Amazon. Dolphin will make some transitional actions at the right time this week, adjusting out the Hang Seng Technology ETF and choosing some semiconductor leaders to enter the position."

Here, Dolphin Analyst will explore in detail in light of recent market changes.

II. Know clearly what money you are earning

This earnings season may give people the misconception that fundamental factors are failing—stocks with poor performance still experience explosive growth. However, in fact, before drawing conclusions about whether the fundamentals are failing or not, it is essential to know that there are mainly two sources of stock price increase: (1) earning valuation and (2) bumping up the EPS.

The company's valuation consists of three primary sections from the perspective of cash flow discounting:

a. Short-term cash flow: similar to short-term performance that can be seen and verified by the naked eye, the corresponding EPS boost can be observed in the short term.

b. Long-term cash flow: by examining the change direction of mid- to long-term indicators during the short-term performance check, one can judge whether the company is on a good track, in good cycle, whether it is building high barriers, and whether it brings changes to long-term cash flow expectations, corresponding relatively mysterious valuation PE increase.

c. Perpetual cash flow: mainly determined by the discount rate, which follows macro Beta; for example, how much is the risk-free interest rate, and how much is the stock and bond risk premium, etc., corresponding relatively mysterious valuation PE increase.

A company whose stock price mainly relies on parts b and c or whose stock price ratio of parts b and c is too high is easy to fluctuate tremendously during significant macro changes without a ceiling or a floor.

However, the pandemic during the past three years has greatly interfered with the market's judgment of the three aspects, especially the unlimited support of US monetary policies in 2020 and the subsequent inflation, which made money that appeared to be earned through EPS actually pumped with water by macro expansion, still being Beta in essence.

III. The market's endless dilemma: deep recession, mild recession, or low growth? Since the return is Beta, the judgment of the maximum macro Beta factor - the global risk-free rate anchored to the US federal policy rate at the "change" node has once again become the key contradiction that affects stock prices. And precisely because of this, the recent market changes have been enormous.

In the previous report, Dolphin Analyst mentioned two hypothetical scenarios: "interest rate cut + mild recession" versus "interest rate cut + deep recession". Until the latest CPI data, the US stock market was still following the logic of "interest rate cut + mild recession", as Dolphin Analyst predicted.

However, the high-frequency macro data in recent times seems to indicate another possibility that the market did not dare to imagine before:

a. On the expectation of an interest rate cut game: There may not be a rate cut this year;

b. On the expectation of economic growth: There may not be negative growth this year, that is, there may not be a recession.

And the combination of these factors in 2023 will result in: A sustained high-interest rate will gradually bring inflation under control, employment will be able to maintain some resilience without showing a non-linear collapse, and the economy will have some resilience, which is exactly what the US Federal Reserve has been hoping for in terms of economic "soft landing". Looking further ahead, after the soft landing, interest rates will gradually return to a position that is consistent with the long-term economic growth.

In summary, the risk of economic slowdown in the short run has decreased, while there is certainty of interest rate cuts to raise valuations in the long run. Under this scenario, there is not much EPS risk for US stocks in the short term (vs. the current market's unanimous EPS expectation for the S&P 500, which is a YoY decline of 1%), and there is a chance for certainty of interest rate cut raising valuations in the long run. Therefore, under this scenario, the relative opportunities for US stocks may exceed Hong Kong stocks.

In the eyes of most people who think in traditional paradigms, this combination of economic scenarios is too bold and unlikely, simply because in their conceptualization, every time the Federal Reserve in the U.S. increases interest rates, it will "break something".

However, from the latest indicators of the US economy, this possibility is not completely impossible: for example, in the first quarter, after marginal economic growth brought about by inventory increases in the fourth quarter, there was no rapid deterioration of the economy in the following indicators:

①An increase in employment of nearly 520,000 in January; ②The expansion of the service PMI (see Figure 1 and Figure 2); ③ The return of retail sales in January (see Figure 3):

The items highlighted in red in the figure above constitute more than 10% of the contribution of retail sales to the overall market. In addition to the surge in restaurant and bar spending, the return of typical retail sales, such as car consumption, as well as the return of various categories that were previously experiencing weak growth, such as clothing and accessories, gas stations, health care and gardening, have brought retail sales back to a somewhat normal level. Finally, retail sales + catering and social services retail sales accelerated YoY growth by 6.7% in the same large market. ④Although there have been occasional rises, the confirmation of the deflation channel has been initiated:

Under such economic growth, what can be determined for the key inflation indicator in January, ex-housing core CPI, is that the trend of deflation has not reversed, only slowed down slightly. Because the trend itself shows that the unexpected difference is:

a. Even after the inflation rate in the past few months has been adjusted under the new weight, the YoY of US core CPI ex-housing in January is only 3.9%, which does not seem to be a particularly terrifying number. The MoM is 0.2%, which means that if the trend of this MoM growth rate continues for one year, the YoY after one year will only be 2.4%.

b. This ex-housing core CPI is further divided, and removing goods shows that the remaining service inflation that is highly related to this wave of inflation sticking is the real hard bone in the next stage of the inflation easing process: the MoM for service inflation is 0.6%, which basically corresponds to 7.4% YoY.

Therefore, the current state of key economic data is: except for inflation in service categories where there is high human input (education, entertainment, etc.), most others have basically reached the progress of deflation with relative certainty.

But so far, the economic operating data is still good. Of course, it can be said that the effect of interest rate hikes has not been fully reflected, but in the opinion of Dolphin Analyst, there is a reason for this wave of epidemic economic cycles in the unique characteristics of the supply and demand market of labor force:

1. Trending supply shortage meets additional demand

a) Here, we introduce a basic information:

The current total population of the United States is 334 million. After excluding those under 16 years old, serving in the military, and being detained, the total pool of people with labor capacity was 266 million as of January this year.

However, in this pool, there is a group of people who have labor capacity but no willingness to work for compensation, such as retirees, students, housewives, and some who have been unemployed for too long and have given up directly. In January, there were about 100 million such people.

c Taking out these remaining people is the labor force. The labor force is divided into employed and unemployed people (see the specific definition in the figure below).

b) Supply side: Looking at the total pool of the current labor supply in the United States – 266 million people – it can be seen from the trend that this number has been on a long-term downward trend since 2020 (even after a surge of 1 million people in January) and there are still some small gaps away from the long-term trend. Of course, a more serious problem is that the labor participation rate has yet to recover to pre-epidemic levels, which means that the labor force is short of about 1.7 million people.

c) Demand side: Assuming a job vacancy of 10.3 million in January combined with a significant increase in employment, with 5.64 million people awaiting employment, and according to normal labor supply and demand trends in 2019 before the pandemic – where one unemployed person corresponds to 1.2 job vacancies – the theoretical shortfall should be less than 7 million people, but the actual gap is now about 3-3.5 million people.

The combination of these two factors leads to a rough conclusion that the decrease in labor participation rate has led to a shortage of 1.7 million workers in the labor supply, while, at the same time, the demand for labor has increased by an additional 1.5 million people, resulting in a supply-demand imbalance and a shortfall of 3-3.5 million workers.

Employment resilience brought about by supply problems:

The decline in labor force participation is to some extent a long-term "scar" left by the epidemic, which is very difficult to improve quickly. Currently, the only way to make up for the shortfall is to focus on the demand side.

The only sectors that have shown a clear trend of layoffs after the epidemic are the information and financial activities industries and the auto manufacturing sector in the manufacturing industry, but these industries are not labor-intensive.

In terms of absolute employment, assuming that the information and financial services industries reduce their workforce by about 6% according to Google's standards, with an additional labor supply of over 600,000 people, this is only enough to supplement the additional job demand in a particular sector compared to before the epidemic.

Moreover, it can be clearly seen that the two major industries that currently have a relatively high number of job vacancies, healthcare and social assistance and food service, are not interest-sensitive industries, and the corresponding consumer demand in these two industries is relatively rigid and insensitive to interest rates, and high interest rates are not likely to hit the demand in these industries.

After understanding this information, it is not difficult to make the following inference: 1. From the perspective of demand: In the post-pandemic period, there is a shortage of labor in service industries that are labor-intensive. These industries require individuals to fulfill their obligations, and this kind of service production cannot be quickly replaced by machines, nor can it be mass-produced like goods.

2. From the perspective of supply: The pandemic has caused structural trauma to labor force participation, resulting in a large supply gap.

It is impossible to solve this problem simply by increasing interest rates, because it is a structural shortage of personnel in the industry. In addition, interest-sensitive industries may also lay off employees (such as the real estate and automotive industries), and layoffs have already occurred in the information and financial industries, and even in the transportation industry.

Therefore, the possible result may be: relatively high turnover rate + seriously high employment rate + low basic salary for blue-collar workers in the salary structure + a surplus of high-salary white-collar workers, and the overall salary inflation cannot be transmitted across industries, resulting in the average salary growth rate of the whole society being lower than the employment growth rate, and salary and inflation cannot form a spiral.

3. Economic growth prospects: perhaps it is just slow growth in residents' income?

The United States is a low-saving, high-consumption society, and a very typical feature is that most of the money spent every month is spent on consumption. For example, if someone earns 100 dollars a month, only 4 dollars will be put into the piggy bank, and the rest will be spent.

In other words, for the United States, if there is employment, there will be consumption, and if there is consumption, there will be economic growth. In the case of this structural shortage of personnel, the unemployment rate does not seem to have soared significantly.

a) After a round of pandemic stimulus, the household debt-to-income ratio is not that high

Especially after this round of pandemic stimulus, from the perspective of macro debt increase, the federal government has seen a significant increase in leverage, followed by a slight increase in corporate debt, while the macro debt-to-income ratio of the household sector and local governments has declined. Currently, aside from the fact that the Ministry of Finance needs to increase the debt ceiling to repay national debt other than the due debt, the other departments do not seem to have significant problems.

b) How much room is there for household debt consumption?

Looking at the three major credit projects of households in detail - home mortgage loans (accounting for 71% of the balance), auto loans (9%), and consumer loans (6%): in the last quarter of last year, when the basic interest rate really rose to a relatively high level, the growth of new home mortgage loans quickly fell back to the level of 2019, but car loans and consumer loans that required debt consumption are still relatively strong.

However, the outstanding ratios of delinquent loans that have transitioned from below 90 days to over 90 days on a marginal basis are auto loans and credit card consumption, but the delinquency rate after the marginal expansion is still slightly lower than the pre-pandemic level (lower by approximately 0.7 percentage points). This also shows that some of the resilient retail sales in the fourth quarter are still relying on borrowing, and the marginal increase in default rates indicates that the consumption power of borrowing may dry up in the future.

Considering that the truly high interest rates in the market only exist in the fourth quarter on a single quarterly basis, it is necessary to observe the situation of deteriorating borrowing consumption + default rates after the high interest rates reach a steady state. If borrowing consumption is still thriving, it is likely to increase the difficulty of resisting inflation in the short term and promote the recession risk in the medium term.

Summary: The characteristics of this wave of epidemic economic cycle described in <1-3> are:

1) After the epidemic, there is a structural shortage of labor supply, coupled with many excess job demands on the demand side (catering + medical), which are not sensitive to interest rates. This makes the employment market's ability to withstand rate strikes particularly strong in this cycle. This means that after the transfer payment is reduced, residents' consumption based on the income they earn themselves still has resilience.

2) After the "helicopter money" was distributed, for a demand-driven country like the United States, residents' asset-liability risks were taken over by the government, and their situation improved even further after the epidemic. The risk of the federal government is currently mainly reflected in the issue of the national debt ceiling, as evidenced by the end of the fourth quarter, the risk of the asset-liability table of residents at the government level is not large as long as they do not incur further borrowing consumption, while the level of federal government risk is mainly reflected in national debt ceiling issues.

3) The US economy is typically driven by domestic demand. If there is no significant risk to residents' asset-liability ratios and only slow income growth, in the four major scenarios of "stagflation, weak recession, deep recession, and light growth", subsequent transactions may occur more frequently between weak recession and light growth.

IV. Market fluctuations under the rush, and the mismatch of opportunities between Hong Kong and the United States

The economic outlook of either shallow recession or light growth is better than the deep recession and stagflation logic that the market traded some time ago. However, due to the changing situation, coupled with the resilience of employment, based on the macro high-frequency data disclosed in single points, it is easy to cause market fluctuations back and forth. However, Dolphin Analyst believes that when the single point data are strung together:

a. The probability of light growth and shallow recession is further increasing, and the overall probability of US stocks fluctuating upward will be greater than that of fluctuating downward.

b. However, it should be noted that under expectations of light growth, the US dollar may be relatively strong, and the excessive pricing of renminbi exchange rate in Hong Kong stock market trading will lead to a pullback in Hong Kong stocks when the renminbi falls. Under this macro expectation, Dolphin Analyst suggests focusing on companies with intact competitive structures and industry positions, selecting stocks based on both high business cycle momentum (such as Airbnb) and cyclical reversals (such as Amazon).

This article concludes the discussion on individual stock and industry selection, and Dolphin Analyst will further elaborate in subsequent summaries, stay tuned.

For more past US stock macro summaries:

November 8, 2022 "Amazon, Google, Microsoft, Are The Giants Falling? US Stock 'Meteor Shower' Continues"

May 30, 2022 "Only Downturn Can Defeat the Inflation Tiger?"

May 9, 2022 "Can US Stocks Survive the Lightweight Oil Crisis with Attacks From All Sides?"

February 14, 2022 "US Stock Craze Ends, Too Many People Skinny Dipping"

December 3, 2021 "Who Will Be Next, Is There Still a Second Half for Google, Meta, and Netflix?"

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