Handwringing Over Inflation, Fed Could Use More QT, How I'm Trading Microsoft

Each tiny speck of sand, one by one. Plunk. Plunk. Plunk... The countdown is over.

This afternoon, the Federal Open Market Committee will once again make the decision on the future of US monetary policy. There has been little uncertainty regarding the Federal Reserve's intentions for this FOMC meeting. On June 14, during the committee's last policy meeting, the central bank decided to keep the fed funds rate steady within the range of 5% to 5.25%. Fed Chairman Jerome Powell and his team made it clear that the decision to hold rates steady in June was simply that - a decision to not take action. They emphasize that economists, financial market participants, and the general public should not interpret this inaction as anything more than a pause.

There are clear reasons for slowing down the process of tightening monetary policy. The effects of monetary policy on everyday people and businesses are believed to occur with a delay of about six to nine months. This means that the actual economic activity in the real world was still in the process of adjusting to the changes made by the FOMC (Federal Open Market Committee) to short-term interest rates and the overall money supply for a period of around 18 months. These changes included a series of 10 policy decisions resulting in rate hikes, which concluded in June. Interestingly, this was also the same month when the Consumer Price Index, a measure of inflation, showed a year-over-year growth rate of 3%. This marked a decrease from the peak inflation rate of 9.1% observed in June 2022 and was the slowest annual growth rate since March 2021. Additionally, the core CPI, which excludes volatile food and energy prices, grew at a rate of 4.8% in June, the slowest pace since late 2021.

The focus here is on the conflict between the decrease in consumer inflation due to the easing of post-pandemic shortages, and the possibility that this success in lowering consumer prices may have reached its limit. As we mentioned earlier, June 2022 is expected to mark the highest point of inflation, making year-over-year comparisons more challenging going forward. There are a few factors that are likely to contribute to inflationary pressures but have not yet had an impact. One factor is the potential for increased demand from China through fiscal measures. Another factor is Russia's decision to stop allowing Ukrainian grain to be sold in global markets. Lastly, the weakening of the US dollar compared to other major currencies as markets speculate about the end of the Federal Reserve's tightening policies.

After understanding all of that, there is another struggle that involves the conflict between the forces of rising prices and their counterparts who aim to reduce inflation, but it is much bigger than that. The larger struggle is between economists who believe that the Federal Reserve has taken enough measures to control inflation and that the economy can handle it from now on, and economists who believe that the Federal Reserve will need to significantly slow down the US economy or even worse, in order to prevent a likely resurgence in the increase of consumer prices. This would mean that the Federal Open Market Committee (FOMC) would need to further restrict credit markets, to the extent that it visibly harms the job market, thus causing the velocity of money to decrease. Recently, wage growth has exceeded the growth of consumer prices. These economists consider the idea of a potential "soft landing" for the US economy to be counterproductive in the long term.

These economists, who make a valid argument, believe that there is still too much money circulating in the economy. Despite the Federal Reserve's efforts to reduce the amount of money in circulation, the progress made so far has been small compared to the massive expansion of the Fed's balance sheet during the pandemic and after the Great Financial Crisis. Currently, the Fed's balance sheet is $8.275 trillion, down from its peak of $8.965 trillion in April 2022. In February 2020, the Fed's balance sheet had assets worth $4.158 trillion. This means that the balance sheet has grown by 116% over a little more than two years, and has only contracted by less than 8% over a year and a half. Even when considering factors like population growth, it is clear that there are valid reasons for being cautious and vigilant about the possibility of prices for goods and services increasing again.

As a person who understands both economics and trading, I often find myself conflicted when considering future policies. If I were in Jerome Powell's position after raising the fed funds rate to 5.25% to 5.5%, and even if I were considering indicating a larger pause in rate hikes at the upcoming Jackson Hole meeting, I would try to present the central bank as more aggressive than what the futures markets perceive it to be during the press conference. Additionally, I believe that the Fed could slightly speed up its quantitative tightening program, possibly without attracting too much attention, as compared to forcibly maintaining the inverted slope of the Treasury yield curve.

Microsoft's performance in the last quarter was impressive, which is no surprise since they consistently do well. In the fiscal fourth quarter that ended on June 30th, Microsoft reported earnings per share of $2.69 and revenue of $56.865 billion according to Generally Accepted Accounting Principles (GAAP). As a Microsoft investor, Action Alerts PLUS was pleased to see that Microsoft exceeded expectations for both revenue and profit. The top-line results showed an 8.3% increase compared to the previous year, and gross income grew by 11.2%. Additionally, Microsoft's gross margin improved from 68.32% to 70.11%, surpassing the general consensus.

Sales exceeded expectations in all of Microsoft's reporting divisions. The segments of Productivity and Business Processes, Intelligent Cloud, and More Personal Computing all outperformed their projected estimates. However, in terms of operating income, both Productivity and Business Processes and Intelligent Cloud surpassed expectations, while More Personal Computing fell short.

Below the exterior, the primary focus for many individuals nowadays when Microsoft presents its reports is the expansion of Azure cloud services. Azure experienced a 26% increase in revenue compared to the previous year (27% in terms of currency value), which, despite being in accordance with predictions, demonstrated a decline from the impressive 45% growth witnessed a year ago.

Microsoft continues to generate strong free cash flow. The cash flow from its operations increased by 16.8%, amounting to $28.77 billion. At the same time, the expenditure on capital expenses, particularly in the area of artificial intelligence, grew by 30.2% to $8.943 billion. As a result, the company's free cash flow reached $19.827 billion, marking an 11.7% increase compared to the previous year. From this amount, Microsoft gave back $9.7 billion to its shareholders, while maintaining a healthy cash position of $111.3 billion on its balance sheet. The current ratio, which measures the company's ability to cover its short-term liabilities with its current assets, stood at 1.77, a slight decrease from 1.91 three months ago. It is important to note that the current unearned revenue, which is not considered a true financial obligation, amounted to $50.901 billion, making up 48.9% of the company's current liabilities. However, excluding this entry, the current ratio improves to 3.46, which is consistent with Microsoft's position three months ago. This indicates that there has been no significant decline in the company's overall financial health.

The directions given were a bit challenging. They had to be that way. I believe, or at least I do, comprehend that. The forecasted income was slightly below expectations for the More Personal Computing division. The predicted income from cloud services was also on the cautious side. However, Microsoft is still anticipating a 25% to 26% increase in sales for Azure, taking into account currency fluctuations. Profitability might be impacted negatively.

The company has shifted its focus to making investments and plans to continue doing so in the next year. Why is this necessary? In order for Microsoft to remain a strong competitor in the market and meet the increasing demand for cloud services and their generative AI projects, they need to invest before they can reap the rewards.

By adopting this method, Microsoft will maintain its operating margin unchanged while investing, thereby avoiding the possibility of short- to medium-term growth. This might also put at risk the substantial amount of free cash flow generated in the past few quarters. Nevertheless, Microsoft has managed to accumulate a considerable amount of cash over time and has continued to grow that reserve in the latest quarter.

Dedicated followers are well aware that Microsoft has been the largest part of my investment portfolio for quite some time. Although it will certainly have a negative impact on my overall returns today, Microsoft has consistently performed well. (If I hadn't sold my shares of Nvidia (NVDA) earlier this year for a profit, that stock would currently be my top holding. However, I need to make money in order to sustain myself, and I can only achieve that by making profitable investment decisions. Therefore, I have to make necessary sales.)

For those who have followed my recent interview on TD Network with Nicole Petallides, it would be apparent that I am worried about the stock's inability to break through the $370 mark, which has been the crucial point for me. This concern arose after the shares surpassed their previous highs from late 2021 and June this year. Now, let's delve deeper into this matter...

Readers will notice that the stock of MSFT concluded on Tuesday at approximately $351. The Relative Strength indicator has recently decreased, indicated by the daily MACD setup in July. This setup displayed a bearish cross-under of the 26-day exponential moving average by the 12-day EMA. Currently, the shares are trading at around $337, experiencing a nearly 4% decrease overnight.

There are currently two important factors affecting the value of the shares. People who have invested in this company hope that the stock will remain above its 50-day simple moving average (SMA), which is currently at $333. It is also crucial for them to see that the lower trend line of our Pitchfork model, which currently sits at $320, remains intact. If this model's lower limit is breached, it could potentially lead to a decline towards the 200-day line, which is something we definitely want to avoid.

Price Goal: $425 (reaffirmation)

Pivot: $370 (unless the situation shifts, then the goal will also alter)

New: Reduced to $320 (at the moment) from $333.

Distress: Breach of Pitchfork's declining support line (by distress, I imply a gradual reduction, not complete withdrawal)

Due to numerous inquiries I received, it seems that there may be others who are also curious. I indeed made an investment in Raytheon RTX yesterday, and I intend to pursue further opportunities if the stock price dips below $82 in the near future.

Economics - In Eastern Time

07:00 - MBA 30 Year Mortgage Rate (Weekly): Previous rate stood at 6.87%.

At 07:00, there will be the release of the MBA Mortgage Applications report, which provides information on the percentage change in the number of mortgage applications compared to the previous week. The latest reading showed a 1.1% increase.

At 10:00, the data for new home sales in June will be released. It is predicted to reach 724,000, while the previous report recorded it at 763,000 on a seasonally adjusted annual rate (SAAR).

10:30 - Weekly Report on Oil Supplies: Previous week recorded a decrease of 708,000 units.

10:30 - Weekly Gasoline Inventory: Previous reading indicates a decrease of 1.066 million units.

Eastern Standard Time: The Fed's Schedule

2:00 PM - Federal Open Market Committee Policy Decision.

2:30 PM - Federal Open Market Committee Press Conference.

Today's Earnings Preview

Pre-Market Report: AT&T has gained 0.61 points, Boeing has dipped 0.89 points, Coca-Cola has risen by 0.72 points, General Dynamics is up by 2.60 points, Thermo Fisher Scientific has seen a significant increase of 5.43 points, and Union Pacific Corporation has gained 2.75 points.

End of Day Summary: (CMG) (12.28), (LHX) (2.95), (LRCX) (5.13), (NOW) (2.05), (URI) (8.94)

(MSFT, CMG, and URI are part of the stocks that TheStreet's Action Alerts PLUS portfolio holds. Do you want to be notified in advance when the portfolio decides to buy or sell these stocks? Find out more today.)

Receive an email notification whenever I publish a new article on Real Money. Simply click the "+Follow" next to my name to stay updated.