March 13, 2023
February labor market data eased slightly from the hot January readings, but remained stronger than expected – and likely too strong for the Federal Reserve’s (“Fed”) comfort – confirming that January reflected ongoing momentum, not just seasonal abnormalities. Initial jobless claims did perk back above 200k this past week, but otherwise remain range-bound at low levels. JOLTs once again confirmed labor demand far exceeds available supply, and nonfarm payrolls increased a stronger than expected +311k in February, but were partially countered by a higher unemployment rate and more modest wage gains.
A temporary decline in mortgage rates in January provided the housing market a brief respite, leading to a pickup in existing home sales, stabilization in home prices and a modest rebound in builders’ sentiment. However, that was short-lived as rates rebounded back above 7%, causing mortgage applications to plunge once again. Auto sales are rebounding as production gradually improves, allowing pent-up demand to get filled, but this too is unlikely to last long. Consumer sentiment had been improving off 2022’s lows, especially as job and wage growth remained strong and inflationary pressures eased. However, as reflected by the Conference Board’s latest survey, confidence fell in February, and consumers still have a historically pessimistic future outlook for the economy. The Atlanta Fed GDPNow continues to project faster Q1 growth (+2.6% q/q A.R.) than the Blue Chip Consensus, which is beginning to close the gap with GDPNow. Lastly, the Cleveland Fed’s inflation NowCast points to the likelihood that inflation continues to track higher for February and March as goods deflation lessens and services inflation remains elevated and sticky.
Jay Powell seemingly put a +50 bps rate hike back on the table for the March FOMC meeting during his Congressional appearance last week, but the demise of Silicon Valley Bank (“SVB”) (and fears of contagion) quickly reduced that likelihood and instead opened the door to a “pause.” The fallout from SVB is still to be determined, but regulators were working feverishly over the weekend to limit the damage and calm fears. A key question now is whether the Fed abandons its inflation fight for the sake of financial stability.
Meanwhile, S&P 500 earnings estimates continue to be revised lower. To the extent that wage growth remains elevated and sticky while pricing power weakens, corporate profit margins remain at risk. As such, with equity valuations still full, earnings estimates still falling, investor sentiment still too hopeful, and now a banking crisis emerging at the same time the Fed is working to combat inflation, market risks are particularly elevated. The Fed must deftly navigate these treacherous waters without committing a policy mistake, a highly uncertain proposition to be sure. At a minimum, this situation would seem to argue for a higher equity risk premium, and thus lower P/E multiples.
February 28, 2023
January macroeconomic data came in hot: hot jobs, hot spending, and hot inflation. Initial jobless claims remain stubbornly below 200k and have been trending sideways for the better part of the past year, suggesting no material softening of the job market. While it is doubtful that we will get the same level of job gains we had in January, which received an extra boost from warmer-than-normal weather along with seasonal adjustments, February is likely to remain +200k or better. January retail sales rebounded strongly from softer November-December readings, while personal spending in January confirmed the resilience of the consumer, who continues to be supported by strong job/wage gains and excess savings. Lastly, all three key inflation gauges – Consumer Price Index (CPI), Producer Price Index (PPI), Personal Consumption Expenditure (PCE) – were hotter than expected in January, on top of upward revisions to prior months. The Cleveland Federal Reserve’s inflation NowCast currently indicates little relief in February. As a result of all this stronger data, the Atlanta Federal Reserve’s 1Q GDPNow has been revised further upward from +0.7% to +2.7%.
In our opinion, the much discussed “no landing” scenario for the economy is simply a “hard landing deferred.” Either (a) the economy weakens and inflation comes down, and profits disappoint; or (b) the Federal Reserve will continue to tighten, increasing the risk of an even harder landing. Either way, the message remains: “Don’t fight the Fed.”
As highlighted by Credit Suisse, the fourth quarter earnings season was one of the worst outside of a recession in the past 25 years. Actual earnings underwhelmed with below-average beats on estimates that had already been revised down more than usual coming into the reporting season. With 95% of the S&P 500 having now reported, fourth quarter EPS looks to be down about 3% year-over-year – the first decline since the pandemic-impacted September quarter of 2020. Based on current consensus estimates it appears we have now entered into an earnings recession (if not an economic recession), and profit margins will continue to be at risk so long as costs continue to rise faster than revenue.
Market risk remains elevated with valuations full, earnings per share estimates falling, investor sentiment still optimistic, and market volatility (as measured by the VIX, the Cboe Volatility Index) still reflecting complacency – especially now that reaccelerating growth and inflation means that the Fed must take rates higher for longer.
February 13, 2023
The stock market rally to start this year has been a function of defensive positioning entering 2023, “Goldilocks” data that boosted investors’ soft landing hopes, and a favorable November thru April seasonal trading period amplified by the third year of a Presidential Cycle (a historically strong year for the market).
Contrary to the soft landing hopes that might encourage the Federal Reserve (“Fed”) to soon pause its rate hike campaign, more recent economic data suggests that both growth and inflation may be reaccelerating here in the first quarter. First, we received a trifecta of strong employment data: (1) Job Openings and Labor Turnover Survey (JOLTS) is back up to 11 million, (2) initial unemployment claims are back below 200k, and (3) nonfarm payrolls came in much stronger than expected with a +513k jobs gain in January (along with a significant upward revisions to prior readings). Second, January consumer spending also appears to have rebounded from soft November and December levels, confirmed by Visa and PayPal volumes, Bank of America’s own credit card data, and EvercoreISI Retailers’ Survey. Third, reflecting this pick-up in growth, the Atlanta Federal Reserve’s Q1 GDPNow estimate has been revised up from +0.7% to +2.2%.
On the inflation side, upward revisions to the Bureau of Labor Statistics’ Consumer Price Index (CPI) last week indicated inflation readings in the second half of last year were actually higher than previously reported. The latest Employment Cost Index for last year’s fourth quarter, along with January’s average hourly earnings and the Atlanta Federal Reserve’s Wage Tracker, suggest that wages, while moderating from last year’s highs, may now be plateauing at a level that would be inconsistent with the Fed’s 2% inflation target. Lastly, the Cleveland Federal Reserve’s inflation NowCast points to the possibility of a near-term inflation scare with January and February CPI estimates that are tracking above consensus expectations and a significant reacceleration from November and December.
Meanwhile, fourth quarter earnings season has been one of the worst outside of a recession in the past 25 years with actual earnings disappointing relative to estimates that had already been revised down more than usual coming into the reporting period. With roughly 80% of the S&P 500’s market cap having reported, earnings look to be down around 2% year over year for the December quarter, marking the first decline since the pandemic-impacted September quarter of 2020. Forward EPS estimates also continue to get revised lower, primarily on weaker profit margins, suggesting we are likely now entering an earnings recession.
With stock valuations now higher, earnings per share estimates lower, investor sentiment more bullish, and market volatility lower (as measured by the VIX, the Cboe Volatility Index), the market may be set up for disappointment, especially if faster growth and higher inflation means that Federal Reserve Chairman Jay Powell is correct that the Fed must take rates higher for longer than the market is discounting.
January 30, 2023
The market has gotten off to an impressive start in January with a “risk on” rally led mostly by smaller caps and more economically sensitive stocks, along with many of last year’s worst performers. Investors have been emboldened by cooling inflation data and a resilient job market, bolstering hopes for a more dovish Fed and an economic soft landing.
While recession signals continue to mount, the most reliable concurrent indicator, initial jobless claims, continues to suggest “not yet.” Entering this week’s Federal Open Market Committee (FOMC) meeting, evidence of slowing inflation is unmistakable, but it still seems premature for the Federal Reserve (“Fed”) to declare “Mission Accomplished.” The three drivers of the Fed’s reaction function in our view remain: (1) continued progress on moderating inflation back towards its 2% target; (2) evidence that the labor market is in fact cooling and wage growth is slowing; and (3) avoidance of a premature easing of financial conditions. A case can certainly be made for the first, but unfortunately, the labor market remains historically tight and financial conditions have continued to ease, raising doubt about the sustainability of progress towards the target.
Thus, while the Fed likely downshifts again to a +25 bps rate hike this week, we expect the language/guidance from Fed Chairman Jay Powell to remain hawkish (i.e. tighter for longer) to counter easing financial conditions. With deflation in commodities, goods, and housing unfolding, the Fed is now singularly focused on the stickiest element of the inflation picture – wage growth; therefore this week’s Employment Cost Index (ECI) release will be closely watched and analyzed.
We are now roughly one-third through the earnings season. The volume and magnitude of the earnings beats has been less than usual, and cautious outlooks are driving downward estimate revisions as we anticipated. Stock reactions, however, have been unusual and confounding as misses have generally been rewarded and beats have gotten punished. We remain doubtful that this bear market has fully run its course and await further evidence of investor capitulation on the economic and earnings outlook for the year ahead.
January 17, 2023
The stock market has gotten off to a solid start this year, no doubt encouraged by the Goldilocks set of economic data releases the past two weeks showing resilient growth and cooling inflation, which is emboldening the “this time is different” soft landing calls. Although we anticipate another downshift to a +25 basis point increase in interest rates starting with the February FOMC meeting, it is unlikely that the Federal Reserve (“Fed”) diverts from its current path of tighter for longer. Going forward, we believe the Fed reaction function will be dictated by three factors: (1) continued progress on moderating inflation; (2) evidence that the labor market is in fact cooling and that wage growth is slowing; and (3) avoidance of a premature easing in financial conditions.
The U.S. economy has remained resilient thanks to the strength of consumer balance sheets, along with abundant job and wage growth; however, recession signals are mounting. Deflation in commodities, goods, and housing is unfolding, but the Fed is now primarily focused on cooling the labor market in order to cool robust wage growth that underpins core services excluding housing inflation. Investor attention, however, will now turn to earnings as we enter what is likely to be a consequential earnings season. We expect to see more evidence of margin pressures, especially as pricing power weakens while labor costs remain elevated and sticky. We also expect more conservative initial outlooks for 2023 as CEOs anticipate more difficult economic conditions ahead, which should result in downward earnings revisions.
It is doubtful that the bear market has fully run its course. We continue to patiently wait for further evidence of investor capitulation on the economic and earnings outlook for this calendar year. As economic and earnings recession forecasts become reality, it should catalyze a “cathartic” volatility spike and lead to a more compelling risk/return opportunity for stocks.
January 3, 2023
The Federal Reserve (“Fed”) is continuing to tighten into slowing growth with higher rates and a shrinking balance sheet. The tightening campaign is not isolated to the United States. Central banks, excluding China, are tightening around the world. The Bank of Japan was the latest to start down the path of normalization and others such as the European Central Bank and the Bank of England are playing catch up, which should remove an anchor on US bond yields.
While the economy has remained resilient due to the strength of consumer balance sheets along with abundant job and wage growth, recession signals are mounting. Importantly, the market has never bottomed BEFORE entering a recession. The Fed now seems awfully close to projecting a recession itself. The Fed’s December “dot plot” showed higher inflation, slower growth, and an increase in unemployment in 2023 that has historically been consistent with recessions. While commodities, goods, and housing deflation is unfolding, the Fed is now primarily focused on cooling the labor market in order to combat robust wage growth underpinning services excluding housing inflation.
We are likely reaching the point where the direction of the stock market will be less about the Fed and more about the consequences of the Fed’s tightening campaign. We expect more earnings downside ahead as the lagged effects of tighter monetary policy ripple through the economy and profit margins come under pressure. It is doubtful that the bear market has fully run its course. We continue to patiently wait for further evidence of investor capitulation on the economic and earnings outlook for this coming year. As economic and earnings recession forecasts become reality, it should catalyze a “cathartic” volatility spike and lead to a more compelling risk/return opportunity for stocks.
December 19, 2022
Once again, the Federal Reserve (“Fed”) confirmed last week that it isn’t finished and intends to continue tightening into slowing growth. While this greatly raises the risk of a recession, these actions are necessary to maintain the Fed’s inflation fighting credibility and prevent a premature easing of financial conditions. In December 2018, the market fell sharply after Fed Chairman Jay Powell insisted on continuing to tighten into slowing growth (Quantitative Tightening on “autopilot”), only to backtrack in early January once the pain got too much to bear. Fast forward to today, the Fed is once again insisting on tightening into slowing growth. However, the key difference today is that inflation is much higher. In December 2018, the CPI was +1.9% year-over-year, compared to an estimated December 2022, CPI of +6.8%. The Fed won’t be as likely to backtrack this time around.
As recession signals abound (sharply inverted yield curve, weakening LEIs and PMIs, and Fed surveys to name a few), it is worthwhile to point out that the market has never bottomed before entering a recession. The Fed itself now seems awfully close to projecting a recession. December’s Summary of Economic Projections (“SEP”) for year-end 2023 showed higher inflation (core PCE +3.5%, up from prior +3.1%), higher Federal Funds rates (terminal rate raised to 5.1%, from 4.6%), higher unemployment (4.6%, up from prior 4.4%), and slower growth (real GDP +0.5%, down from +1.2%). The projected increase in unemployment, in particular, is typically associated with recessions. The problem is that even though growth is slowing and inflationary pressures are easing, the labor market remains too tight and wage growth too strong, underpinning services inflation excluding housing, which accounts for over half the Core PCE – the Fed’s preferred inflation gauge. This is why the Fed must continue tightening until it is confident of achieving its goal of slowing inflation back to its 2% target.
We are likely reaching the point where the direction of the stock market is likely to be less about the Fed and more about the ramifications of the Fed’s actions (i.e. impact on earnings). More earnings downside is likely ahead as the lagged effects of tighter monetary policy ripple through the economy and profit margins come under pressure. It is doubtful that the bear market has fully run its course. We continue to patiently wait for further evidence of investor capitulation on the economic and earnings outlook for next year. As economic and earnings recession forecasts become reality, it should catalyze a “cathartic” volatility spike.
December 5, 2022
Growth is slowing and inflationary pressures are easing, but as last week’s job report indicates – the labor market remains too tight and wage growth is accelerating, which underpins services excluding housing inflation, keeping overall inflation elevated and sticky. Thus, even if the Federal Reserve (“Fed”) downshifts the pace of hikes, it is not finished and must continue to work to tighten financial conditions in order to cool aggregate demand and get inflation down to its long-term target. As a result, rates will continue to move higher and quantitative tightening will continue to drain liquidity, but we are reaching a point where the direction of the stock market is likely to be less about the Fed and more about earnings. With the yield curve already inverted, among other emerging recession signals, the Fed is at risk of overdoing it, which has obvious implications for the economy and profits (i.e., hard landing).
A moderation in the pace of hikes is a recognition of how historically aggressive the Fed has already been and an understanding that monetary policy acts with long and variable lags. Those lagged effects of tighter policy rippling through the economy likely mean more earnings downside ahead.
The key elements of the bull market narrative: (1) peak Fed, (2) peak China Zero Covid, (3) peak Putin – have now largely been realized. The market has rallied to the top-end of the range and is currently overbought, and investors have turned more bullish and complacent, which means stocks are likely poised to rollover and retest the October lows. We remain skeptical that this bear market has fully run its course and continue to wait for further evidence of investor capitulation on the economic and earnings outlook for next year. We believe that the more aggressive the Fed is now, the sooner inflation can be vanquished and the market can bottom, setting the stage for the next bull market.
November 23, 2022
The U.S. economy and the labor market continue to show resilience, but the Federal Reserve (“Fed”) still has “a way to go” before being sufficiently restrictive. Inflationary pressures are easing, but wages and rents remain elevated and sticky. While October inflation readings were cooler, it might have been a “head fake” caused by a one-time government adjustment to health insurance costs. Regardless, Fed officials have been quick to caution against reading too much into a single CPI print and continue to lean towards higher for longer as they fight against the premature easing of financial conditions. While the Fed may soon transition towards a more gradual pace of rate hikes, a pause or a pivot is still a ways off. The risk of a hard landing continues to rise with increases in the “effective” policy rate, which is a combination of the federal funds rate hikes plus quantitative tightening. The bottom line remains that rates are going higher, the Fed’s balance sheet is shrinking, and earnings estimates are falling – all of which are significant headwinds for the market.
We expect more earnings downside as the lagged effects of tighter monetary policy ripple through the economy, revenue slows more quickly than costs, and the strong dollar weighs on multi-national profits. The global economy is heading for a recession; a crisis seems to be looming from the surge in the dollar and bond yields; and geopolitical risks remain elevated. Investor sentiment has bounced higher as excess pessimism lifted on a more hopeful narrative: (a) Fed pivot, (b) China Covid pivot, and (c) Putin pivot. We remain doubtful that the bear market has run its course and are awaiting further evidence of investor capitulation on the economic and earnings outlook for next year.
November 10, 2022
The economy and the labor market continue to show resilience, which should keep the Federal Reserve (“Fed”) in an aggressive tightening posture. While there is growing evidence that inflationary pressures are easing (especially for commodities and goods), wages and rents remain elevated and sticky and therefore so do inflation measures such as the Consumer Price Index (“CPI”) and Personal Consumption Expenditures (“PCE”) deflator. The October CPI report this morning showed a slightly cooler reading than expected, causing a knee jerk rally in the financial markets on the hope this marks the start of a more meaningful moderation in inflation that will allow the Fed to back off its tightening campaign. However, one month is clearly not a trend. As several FOMC members have made clear, it will require a series of data points showing convincing evidence that inflation is moderating back towards their long-term +2% target. As Jay Powell said last week, they still have a ways to go before the job is finished. Rates must go higher and will likely remain in restrictive territory for longer than previously thought.
As a result, the risk of a hard landing continues to increase due to the effects of the rate increases already pushed through plus those still to come. Due to the “long and variable lags” associated with tightening monetary policy, we won’t really know the cumulative effect on the economy for some time. Every time the markets experience a brief rally on Fed pivot hopes, it only delays the inevitable since the Fed must remain resolute to counter the temporary easing in financial conditions. As Jay Powell stated at last week’s press conference, he would prefer to err on the side of too tight over too loose or easing too soon because he views the risks associated with the latter as greater than the former. The bottom line remains: interest rates are going higher, the Fed’s balance sheet is shrinking, and earnings estimates are falling – all of which are significant headwinds for the market.
Third quarter earnings season has produced underwhelming upside against downwardly revised expectations, led primarily by outsized gains from energy companies. Estimates for the fourth quarter and next year have been revised lower, and we expect more earnings downside ahead as the lagged effects of a tighter monetary policy ripples through the economy. As we’ve seen here in the third quarter, profit margins are now contracting, resulting in earnings growth that is much less than revenue growth. For the third quarter, S&P 500 earnings per share growth is likely to be +4-5% year-over-year (-3% y/y excluding energy), despite an +11% y/y increase in revenue (+8% excluding energy). Consensus estimates for 2022 and 2023 S&P 500 EPS growth are now +6% y/y and +5% y/y. Next year’s forecast in particular is likely to prove too optimistic. The global economy is heading towards recession; a crisis seems to be looming from the surge in the dollar and bond yields; and geopolitical risks remain elevated.
Investor sentiment has lifted recently, removing some of the excess pessimism that was present in mid-October. It’s possible we could see a continuation of today’s easing inflation relief rally in the near-term. Still, we continue to believe that the bear market has yet to fully run its course. We await further evidence of investor capitulation on the economic and profit outlook for next year. We also believe that we need to see the dollar and bond yields stop rising to have faith that durable bottom is in place.
October 24, 2022
The economy and the labor market continue to show resilience, which should keep the Federal Reserve (“Fed”) in an aggressive tightening posture. While there is growing evidence that inflationary pressures are easing (especially for commodities and goods), wages and rents remain elevated and sticky, which contributed to another hotter than expected September Consumer Price Index (“CPI”) report. According to the Cleveland Fed’s Inflation Nowcast estimate, inflation relief is unlikely to come in October either. The risk of a hard landing continues to increase with each hot inflation and labor report since it means that the Fed will need to stay the course on tightening financial conditions. The bottom line remains: the Fed continues to raise rates aggressively, Quantitative Tightening (“QT”) is now at full speed, and earnings estimates are falling – all of which are significant headwinds for the market.
Falling earnings per share estimates could drive the next leg down for the market as the lagged effects of a tighter monetary policy begin to ripple through the economy, revenue slows more quickly than costs, and the strong dollar weighs on multi-national profits. The global economy has likely already entered a recession; a crisis seems to be looming from the ongoing surge in the dollar and bond yields; and geopolitical risks remain elevated.
Following a 50% retracement of the post-pandemic bull market (S&P 500 went from roughly 2200 during the pandemic market bottom → 4800 at the January 2022 market peak → to a 3500 low more recently) and sitting on top of its 200-week moving average (key intermediate technical supports for the market), stocks were short-term oversold, investor sentiment was very bearish, and positioning was very defensive, which set the market up for a technical counter-trend rally, not unlike what we saw off the June lows. Better than expected third quarter earnings (relative to lowered expectations) and fresh talk about the Fed slowing/pausing could lead to a little more near-term upside for the market before the rally exhausts itself. In our opinion, the bear market won’t likely end until we get some sort of capitulatory sell off, earnings estimates see more meaningful downward revisions that are consistent with recession, and the dollar and bond yields stop rising.
September 27, 2022
The U.S. economy, and the labor market in particular, continue to show resilience, which is likely a good news is bad news situation. The labor market remains too strong for the Federal Reserve (Fed), which needs to see a material softening to have any confidence that inflation will cool sufficiently. Falling gas prices are providing consumers a welcome near-term reprieve, and there is lots of additional evidence that inflationary pressures are easing. However, wages and rents remain elevated and sticky, which contributed to a hotter than expected August Consumer Price Index report. The Fed subsequently reaffirmed its resolve to bring inflation back down at the September FOMC meeting, hiking interest rates by +75 bps (as expected), but also laying out a tighter for longer forecast, which heightens the risk of a hard landing.
The market seems to finally be taking Jay Powell at his word and is starting to come to terms with the repercussions of an aggressive Fed tightening campaign on the economy. However, we believe the market still needs to more fully discount a recessionary outlook for profits next year. One area where the Fed’s actions are already having a significant impact is the housing market which is now in recession. Declining household net worth – from falling home and stock prices – could cause a negative wealth effect, pressuring consumer spending. The bottom line remains: the Fed continues to raise rates aggressively, Quantitative Tightening (“QT”) has ramped up to full speed, and earnings estimates are falling – all of which are significant headwinds for the market.
The next leg lower for the market will likely come from falling earnings per share estimates as the lagged effects of tighter monetary policy begin to ripple through the economy, revenue slows more quickly than costs, and the strong dollar weighs on multi-national profits. The global economy has likely entered a recession; an economic/financial crisis seems to be looming from the ongoing surge in the dollar and bond yields; and geopolitical risks remain elevated, especially as it relates to an increasingly desperate Vladimir Putin.
The market is currently in the process of testing the June lows, and a decisive break below those levels could lead to another waterfall decline. Stocks, however, are oversold short-term, and sentiment is back to bearish extremes, so another brief counter-trend rally would not surprise us. The bear market, however, won’t likely end until we get a capitulatory panic sell off and the dollar and bond yields stop rising.
September 12, 2022
The economy and labor markets continue to show some resilience. In addition, there is plenty of anecdotal evidence to suggest that inflationary pressures are easing; including falling gas prices, which are providing consumers a welcome near-term reprieve. However, the Federal Reserve (“Fed”) is resolved to bring inflation back down to their long-term 2% target – and there is a long way to go. They will need to see evidence that inflation – both headline and core – is moving convincingly in the right direction, and they are prepared to inflict some economic pain to achieve this. The Fed seems intent on front-loading rate hikes to quickly get to 4.0%, then possibly a pause after that. For now, however, the bottom line remains: the Fed continues to raise interest rates (+75 basis points expected later this month), Quantitative Tightening (“QT”) is accelerating, and earnings estimates are falling – all of which are significant headwinds for the market.
As we’ve been highlighting, it is not advisable to bet against the Fed. As the market comes to terms with the repercussions of an aggressive Fed determined to beat inflation, it will need to more fully discount a recessionary outlook for the economy and profits. Falling earnings per share estimates could drive the next leg lower for the market – with potential for greater downside as the lagged effects of tighter monetary policy begin to be more fully felt throughout the economy and as inflation slows more meaningfully.
The 10-2 yield curve remains inverted (historically an accurate harbinger of recession); geopolitical risks remain (ramifications of Ukraine’s recent counter-offensive gains remain to be seen); dollar strength poses risk for heavily-indebted emerging markets (potential for financial crisis); and China’s “Zero Covid” policy keeps supply chain risks elevated. Post Jackson Hole, valuation, sentiment, and the Cboe Volatility Index (“VIX”) are in “no man’s land” – indicating a higher likelihood of increased market volatility between now and the end of October, potentially providing a more favorable set-up heading into the more market-friendly November to May time period that may coincide with a Fed pause.
August 29, 2022
Federal Reserve (“Fed”) Chairman Jerome Powell delivered a clear and concise message to the markets last week from the Jackson Hole summit that emphasized his resolve to beat back inflation, with a “tighter for longer” message. His comments forced the markets to recalibrate after a hopeful rally off the June lows propelled by poor sentiment, defensive positioning, falling commodities and bond yields, a softer July CPI print, and a belief that Powell may be bluffing.
Our takeaways from the Jackson Hole speech are as follows: (1) while not a done deal, a +75 basis point hike in September is clearly on the table; (2) “neutral is NOT the place to pause or stop”, rebuking hopes for a dovish pivot; (3) Powell abandoned “softish landing” for “household pain”, thus signaling the Fed’s willingness to accept a recession as the price for beating inflation; and (4) Powell invoked Volcker – and not by accident – to signal that he won’t repeat the mistakes of the 1970s.
If indeed the market starts to buy-in on the Fed’s resolve, then it will need to more fully discount a recessionary outlook for the economy and profits, which could drive the next leg lower for the market, suggesting that a retest is quite possible.
Macro-economic data remains mixed, but growth is slowing in spite of a tight labor market; wages and rents will likely continue to exert upward pressure on inflation gauges, and we may not be out of the woods yet on commodity inflation. Earnings per share estimates are coming down, and it is almost certain that there will be further downside as the lagged effects of the Fed’s initial tightening actions starts to be felt more throughout the economy and inflation slows more meaningfully.
The 10-2 yield curve is inverted (historically an accurate harbinger of recession); geopolitical risks remain (Russia using natural gas as a weapon, China saber-rattling over Taiwan); dollar strength poses risk for emerging markets; and China’s “Zero Covid” policy keeps supply chain risks elevated. Prior to last Friday’s rout, valuation on the S&P 500 had bounced from approximately 15x to approximately 18x next year’s earnings; bullish sentiment jumped from approximately 25% to approximately 45%; and the Cboe Volatility Index (“VIX”) had dipped briefly back below 20, reflecting investor complacency was beginning to creep back in. So the preconditions for a giveback of the summer rally – whether in part or whole – seem to be in place; quantitative tightening (QT) will begin draining more liquidity from the financial system next month; and August through October historically have been the most challenging months of the year for the market.
August 15, 2022
August 1, 2022
Evidence of slowing growth continues to mount (housing, initial claims, LEIs, PMIs, regional Federal Reserve surveys) and with two consecutive quarters of negative real GDP in addition to +9.1% year over year CPI inflation – stagflation is here. The debate over whether two consecutive quarters of negative real GDP amounts to a “recession” is more of a political one at this point. All that matters for investors is the impact on corporate profits (modest thus far) and policy prescriptions that may result (none in our view).
Second quarter S&P profits will likely be up between 7-8% year over year, and forward estimates still point to growth, though numbers are now coming down. With the labor market strong and no real “crisis”, and federal debt already so high, no action is necessary from Congress. The Federal Reserve (“Fed”) is in inflation-fighting mode, so no relief is expected there in the immediate future. As data last Friday showed, wages are rising too rapidly (Employment Cost Index “ECI”), consumers are still spending too robustly (Personal Consumption Expenditures “PCE”), and inflation remains way too hot (PCE deflator) for the Fed to take its foot off the brake yet, which is what the recent market rally seems to be anticipating.
The recent rally in the financial markets is self-defeating as the easing of financial conditions runs counter to the Fed’s objective to slow aggregate demand so that supply can catch up and inflation can come down. The bottom line is that we expect the Fed to continue its tightening campaign even as growth continues to slow. The yield curve is inverted (historically a good harbinger of recession), geopolitical risks remain (Russia using natural gas as a weapon, China saber-rattling over Taiwan), dollar strength poses risk for emerging markets, and China’s “Zero Covid” policy keeps supply chain risks elevated. The S&P 500 is likely at or near the top-end of its trading range (4100-4200), investor sentiment has rebounded sharply the past few weeks, and the Cboe Volatility Index (“VIX”) is likely at or near the bottom end of its range (20-22), reflecting more complacency. The conditions are ripe for another market setback in our view, and August and September historically have been two of the most challenging months of the year for the market.
July 18, 2022
Despite recent market optimism on better growth data and a drop in inflation expectations, the reality is that interest rates continue to head higher and earnings estimates are heading lower, which isn’t a great combination. Reports on the labor market and retail sales data were certainly encouraging – indicating that a recession in the traditional sense is not yet upon us. However, inflation continues to run hotter, for longer, which means that the Federal Reserve (“Fed”) has more to do even as the economy is slowing. Falling commodity prices, an inverted yield curve, and lower inflation expectations continue to foster talk about “peak inflation” and “peak Fed”, and a temptation by investors to front-run a dovish pivot. However, the Fed cannot allow stocks and bonds to rise (and financial conditions to ease) until we get “clear and convincing” evidence of moderating inflation. Based on recent comments, Fed officials seem increasingly willing to risk a recession to bring inflation back under control (Powell, “bigger mistake would be to fail to restore price stability”). As such, we believe it is ill-advised to lean against the Fed and what it is trying to do.
With the Fed raising rates into a slowing economy, corporate profits are at risk. The first dominoes have already begun to fall. Walmart, Target, Restoration Hardware, and Micron Technology all took down numbers while acknowledging pockets of weakening demand and bloated inventories, especially for higher priced discretionary goods. Bank earnings didn’t instill much confidence either with J.P. Morgan specifically preparing for deteriorating economic conditions. Last week, we saw a bevy of downward estimate revisions and price target cuts from the sell side. We expect more to come as we progress through earnings season.
It is not unreasonable to think that the market could “over correct” before we have a better sense of the full extent of the downside for the economy and profits, especially with the Fed now actively draining excess liquidity from the markets thru Quantitative Tightening (QT). As such, we believe that it is prudent to remain defensively positioned in higher quality, lower beta issues with higher than normal portfolio cash levels as buying reserves to take advantage of opportunities ahead. Bearish investor sentiment and more reasonable valuations may present preconditions for periodic “relief rallies”, especially on any good (or “less bad”) news, but we would expect those rallies to be short-lived until both geopolitical tensions and inflationary pressures convincingly ease.
July 5, 2022
Evidence is mounting that economic growth is rapidly deteriorating at the same time that the Federal Reserve (“Fed”) is stepping up its tightening campaign, raising the risk of a recession. With Q1 real GDP negative and the Atlanta Fed’s GDPNow estimate of -2.1% for Q2, we may technically already be in a recession. Commodity prices, bond yields, inflation expectations, and Fed futures are falling on growing recession worries, leading investors to believe that inflation may be peaking and that the Fed may soon pivot dovishly. However, the Fed can’t allow a narrative that gives rise to stocks and bonds (easing financial conditions) and will likely quash any attempts to mount a market rally until we get “clear and convincing” evidence of moderating inflation.
The last bastion of strength is the labor market, where job and wage gains have been strong. Initial claims are starting to rise, but we need to see more material softening in labor demand to reduce wage pressures. We’ll get important updates on the labor market this coming week. In the meantime, we are left with a Fed that is increasingly willing to risk a recession in order to bring inflation back under control (Fed Chair Powell: “bigger mistake would be to fail to restore price stability”), which puts profit forecasts at greater risk.
We are expecting downward revisions to the S&P 500 earnings per share beginning with the Q2 reporting season, which could mean another leg lower for the market. The first dominoes have already begun to fall. Walmart, Target, Restoration Hardware, and Micron Technology all took down numbers while acknowledging pockets of weakening demand, especially for higher priced discretionary goods (furniture, home goods, TVs, PCs, smartphones, etc.), and bloated inventories.
It is not unreasonable to think that the market could “over correct”, and so we believe that it is prudent to remain defensively positioned in higher quality, lower beta issues with higher than normal portfolio cash levels as buying reserves to take advantage of opportunities ahead. Bearish investor sentiment and more reasonable valuations may present preconditions for periodic “relief rallies”, especially on any good (or “less bad”) news, but we would expect those rallies to be short-lived until both geopolitical tensions and inflationary pressures convincingly ease.
June 21, 2022
The Federal Reserve (“Fed”) is stepping up its tightening campaign into a slowing economy. Rising initial unemployment claims suggest layoffs are picking up, and a leveling out of the continuing claims series may be a sign that hiring is beginning to slow. Housing demand is weakening due to deteriorating affordability (higher home prices and surging mortgage rates). May retail sales were soft, and various regional Fed surveys also point to slowing activity.
While household balance sheets remain strong, rising gas and food prices are souring consumers and eating into spending on discretionary items. This comes at a time when household spending has shifted away from “stuff” back to “experiences” that had previously been deferred. The May Consumer Price Index (“CPI”) was higher than expected, spoiling the “peaking inflation” narrative. The hot CPI reading, along with worrisome signs within the University of Michigan consumer sentiment survey that longer-term inflation expectations are becoming untethered, forced the Fed to get more aggressive with its rate hikes. We are not hopeful that we will get the “clear and convincing” evidence of moderating inflation that the Fed is looking for over the next several months, which means they will likely have to move forward with another 75 bps hike or two in July and September. As a result, the markets now seem to be pricing in greater risk of recession, though yield curve inversion would likely be a more definitive signal of one in the next year. We’re not there yet. For now, we are still expecting growth in the economy and profits in 2022, though recession in 2023 remains a real possibility.
Surprisingly, consensus S&P 500 earnings estimates for 2022 and 2023 continue to edge higher. However, 10%+ earnings growth this year and next seems highly doubtful in our opinion. Estimate cuts are likely forthcoming as profit margins get pressured by rising input costs and softening sales. Retail inventory markdowns are the first example of this.
Valuations have already compressed pretty significantly this year as investors anticipate falling profit forecasts. Following an 11% drop in the S&P 500 Index over the prior two weeks, investor sentiment is once again deeply bearish, which could fuel periodic brief rallies. However, we are not optimistic that the market will sustain a higher move in the near-term while the Fed remains in an aggressive tightening mode, particularly during the weak seasonal trading period of May to November which could be exacerbated this year by the Presidential cycle. We expect the market to remain volatile and on the defensive until geopolitical tensions ease and we see a “series” of moderating inflation reports.
We continue to monitor the following risks: (1) geopolitical (further Russian escalation/China tensions), (2) margin pressures that may lead to disappointing profits, and (3) further supply shocks and/or aggressive Fed tightening that lead to recession.
June 7, 2022
The US economy is slowing, but a recession doesn’t appear imminent. At the same time, inflation may be peaking, but it’s likely to remain elevated until we get relief from commodity prices and wages. Initial claims suggest layoffs are picking up, but continuing claims indicate that people are finding new work. Housing demand is starting to soften as a result of deteriorating affordability, though limited supply continues to drive strong price gains. This dynamic should change as demand moderates and additional supply comes to the market. Despite poor sentiment, consumer spending remains resilient, but has shifted from physical goods to services. In addition, spending has diverged between low income and upper/middle income consumers who tend to have more assets and excess savings.
The market rallied the past couple of weeks from overly bearish levels on signs of peaking inflation, fueling hopes of a Federal Reserve (“Fed”) “pause” in September and “soft landing” optimism. Based on history though, this appears to be wishful thinking as the Fed has never successfully engineered a soft landing when inflation has been this high and unemployment this low. In the absence of any help on the supply-side, the Fed must cool aggregate demand by tightening financial conditions. In recent interviews, both Jay Powell and Lael Brainard have expressed satisfaction that the financial markets have heeded the Fed’s forward guidance and tightened conditions on their own. It’ll be up to the Fed to follow through. The market appears to be overly fixated on the Federal Funds rate decision – +50 bps vs. +25 bps (or pause) – in September, but Quantitative Tightening (“QT”), which commenced last week, will serve to drain excess liquidity from the system and should be a growing headwind for financial assets.
While not imminent, recession risk is rising. We still expect growth in the economy and profits in 2022, though a recession in 2023 is a real possibility. Calendar years 2022 and 2023 S&P 500 earnings per share estimates continue to edge slightly higher, with consensus still looking for 10% growth in both 2022 and 2023. This outlook seems increasingly at risk, particularly for 2023 calendar year estimates. Profit margins will likely be pressured as input costs continue to rise at a time that companies may be reaching the limits of their pricing power (Target and Union Pacific both lowered guidance today), and thus we anticipate more downward earnings per share revisions ahead. In this environment, high quality stocks are poised to differentiate themselves.
Valuations have compressed, but investor sentiment remains bearish, despite this latest bounce. In addition, we are in a weak seasonal period (May to November) for the stock market. We expect the market to remain volatile and on the defensive until geopolitical tensions ease and “clear and convincing” evidence emerges that inflation is moderating.
We continue to monitor for risks including: (1) geopolitical (further Russian escalation/China moves on Taiwan), (2) margin pressures that may lead to disappointing profits, and (3) further supply shocks and/or aggressive Fed tightening that lead to recession.
May 23, 2022
The US economy is slowing, but a recession doesn’t appear imminent. At the same time, inflation may be peaking, but it’s likely to remain elevated until we get relief from commodity prices and wages. Initial claims suggest layoffs are picking up, but continuing claims indicate that people are finding new work. Housing is starting to soften as a result of deteriorating affordability.
The Federal Reserve (“Fed”) is increasingly hawkish, but continues to slow-play tightening. In the absence of material help on the supply-side, the Fed needs to cool aggregate demand, and thus will maintain pressure on the stock and housing markets (reversing the wealth effect). Powell all but confirmed a +50 basis point hike at the next two Federal Open Market Committee (FOMC) meetings and will then reassess based on the data. Quantitative Tightening (QT) begins next week. The Fed has never engineered a soft landing when inflation is this high and unemployment is this low, which the market has taken to heart the past several weeks.
While not imminent, recession risk is rising. We still expect growth in the economy and profits in 2022, though a recession in 2023 is a real possibility. First quarter earnings season once again delivered positive surprises and upward revisions, despite the recent retail earnings shock. Calendar year 2022 and 2023 S&P 500 earnings per share estimates edged slightly higher, with consensus now looking for +10% for both 2022 and 2023. Margins are increasingly at risk with rising input costs at a time that companies may be reaching the limits of their pricing power. In this environment, high quality stocks are poised to differentiate themselves, through not only financial performance, but pricing power.
The S&P 500 next twelve months price to earnings ratio has compressed (from 21.5x at the beginning of the year to 16.5x at present), and now appears more reasonable on a historical basis. In addition, investor sentiment is very negative. Multiple compression and sentiment readings could provide a setup for a relief rally on any good news pertaining to inflation and/or the Russian Ukraine conflict. Until geopolitical tensions ease however, and “clear and convincing” evidence emerges that inflation is moderating, we expect the market to remain volatile and on the defensive.
We continue to monitor for risks including: (1) geopolitical (further Russian escalation/China moves on Taiwan), (2) margin pressures that may lead to disappointing profits, and (3) further supply shocks and/or aggressive Fed tightening that lead to recession.
May 9, 2022
The global economy continues to slow due to war-related supply shocks and Covid shutdowns in China. While Europe’s and China’s states of decline may pull the global economy down, the U.S. economy, for now, remains strong, supported by a resilient consumer and a rebounding service sector. The labor market remains robust with continued strong job gains and 50+ year lows in both initial and continuing claims. Housing remains strong, but spiking mortgage rates along with rapidly rising home prices are a cause for concern. We are paying close attention for signs that affordability is starting to impact housing demand.
Oil and commodity prices may be peaking which, along with easing supply chain stress, is fueling hopes for peak inflation. However, inflation will likely remain elevated with pressure from rising wages and rents. The Federal Reserve (“Fed”) is behind the curve and increasingly turning more hawkish, but continues to slow-play tightening. Federal Reserve Chairman Jay Powell confirmed a 50 bp rate hike in May and the next couple of meetings and essentially took a 75 bp hike off the table. The Fed also announced the start of the balance sheet drawdown in June. The Fed has never engineered a soft landing for the economy when inflation has been this high and unemployment this low.
While recession risk is increasing, we still expect growth in the economy and corporate profits in 2022. The probability of a recession in 2023 could be 50%. Once again, first quarter earnings season delivered positive surprises and upward revisions. While S&P 500 estimates for calendar years 2022 and 2023 edged slightly lower, consensus is still looking for approximately 10% earnings growth for each of those years. Investor sentiment is very negative as we enter the challenging May to October period for the market, compounded by the Presidential Cycle. We expect the market to remain volatile and on the defensive until geopolitical tensions ease and evidence emerges that inflation is moderating. Rising profits this year have been offset by P/E multiple compression (S&P 500 next twelve months price to earnings have gone from 21.5x to 17.5x).
We continue to monitor for risks including: (1) geopolitical (further Russian escalation/China moves on Taiwan), (2) margin pressures that may lead to disappointing profits, and (3) supply shocks and/or aggressive Fed tightening that lead to recession.
April 25, 2022
The global economy continues to slow due to war-related supply shocks and Covid shutdowns in China. While Europe’s and China’s states of decline may pull the global economy down, the U.S. economy, for now, remains strong, supported by a resilient consumer and a rebounding service sector. The labor market remains robust with continued strong job gains and 50+ year lows in both initial and continuing claims. Housing remains strong, but spiking mortgage rates along with rapidly rising home prices are a cause for concern. We are paying close attention for signs that affordability is starting to impact housing demand.
Oil and commodity prices may be peaking which, along with easing supply chain stress, is fueling hopes for peak inflation. However, inflation will likely remain elevated with pressure from rising wages and rents. The Federal Reserve (“Fed”) is behind the curve and increasingly turning more hawkish. Federal Reserve Chairman Jay Powell essentially confirmed a 50 bps rate hike in May with more to come. The Fed has never engineered a soft landing for the economy when inflation has been this high and unemployment this low.
While recession risk is increasing, we still expect growth in the economy and corporate profits in 2022. Once again, first quarter earnings season is so far delivering positive surprises and upward revisions at the same time that investor sentiment has turned very gloomy. If S&P 500 estimates continue to move higher, with stocks now at the low-end of their recent trading range and sentiment so negative, it would not surprise us to see a brief near-term bounce ahead of the typically weaker May to November seasonal trading period. But until geopolitical tensions ease and evidence emerges that inflation is moderating, we expect the market to remain volatile and on the defensive with rising profits likely offset by a rising equity risk premium (i.e., P/E multiple compression).
We continue to monitor for risks including: (1) geopolitical (further Russian escalation/China moves on Taiwan), (2) margin pressures that may lead to disappointing profits, and (3) supply shocks and/or aggressive Fed tightening that lead to recession.
April 12, 2022
The global economy is clearly slowing due to war-related supply shocks and Covid shutdowns in China. The U.S. economy, however, remains strong for now, supported by a resilient consumer and a rebounding service sector. Transports, however, may be signaling a softening economy at hand. Housing remains strong, but spiking mortgage rates along with rising home prices are a cause for concern. We will be paying close attention for signs that affordability is starting to impact demand. The labor market also remains robust with continued strong non-farm payroll gains and 50+ year lows in both initial and continuing claims. Labor demand continues to exceed supply as indicated in the Job Openings and Labor Turnover Survey (“JOLTS”) that continues to show nearly two job openings for every unemployed individual. Easing Covid worries and rapidly rising wages, however, should continue to pull more workers back into the labor force, helping to improve the supply-demand imbalance.
Rising wages and rents continue to put upward pressure on inflation. The Federal Reserve (“Fed”) is behind the curve and increasingly turning more hawkish. Bill Dudley, former Federal Reserve Bank of New York President, suggested that the Fed would need to “inflict more losses” on the housing and stock markets in order to sufficiently tighten financial conditions to rein in inflation. The Fed has never engineered a soft landing when inflation has been this high and unemployment this low.
While recession risk is increasing, we still expect growth in the economy and corporate profits in 2022. S&P 500 earnings per share estimates continue to move higher, but recession in 2023 may now be a 50/50 probability. We expect the market to remain volatile and on the defensive until geopolitical tensions ease and evidence emerges that inflation is moderating. In the meantime, rising profits will likely be offset by a rising equity risk premium (i.e., P/E multiple compression). The market is likely at the upper-end of a trading range currently. Valuations and sentiment have bounced off recent lows, and the VIX (expectations of market volatility) has fallen, suggesting to us that the market may be susceptible to a retest, especially if the upcoming earnings season disappoints. We’d also note that the May to October time frame is typically a more seasonally-challenged period for the market, but especially so in the lead-up to the mid-term elections following the first year of a new administration.
We will continue to monitor risks including: (1) an escalation of the Ukraine conflict; (2) the possibility that China moves on Taiwan, (3) margin pressures that lead to disappointing profits, (4) spiking commodity prices and/or aggressive Fed tightening that throws the economy into recession.
March 28, 2022
The global economy is being negatively impacted by the Russia/Ukraine conflict, resulting in commodity disruptions and price spikes that threaten demand destruction. A European recession is likely.
Domestically, investors are increasingly on recession watch with intent focus on interest rate yield curves that are at or near inflection – a historically reliable leading indicator of recessions. The U.S. economy remains strong for now, but will likely slow over the coming months. Consumers are buoyed by strong job/wage growth and savings, although sentiment has soured on soaring inflation. The economic reopening is likely driving a spending shift from durable goods back to services like travel, leisure, and entertainment. Supply chain issues are slowly improving, though new constraints continue to pop up in Russia, China and Japan.
Inflation remains highly problematic fueled by rising commodities, wages and rents. The Federal Reserve (“Fed”) is behind the curve and turning increasingly hawkish, though still hopeful for some post-pandemic labor supply relief.
Rapidly rising mortgage rates are beginning to temper some housing demand, but extremely low housing availability and soaring prices continue to support healthy building activity.
U.S. recession risk remains low, but is rising. We still expect growth in the economy and corporate profits in 2022. S&P 500 earnings per share estimates also continue to move higher.
The market is likely to remain volatile and on the defensive until geopolitical tensions ease and evidence emerges that inflation is moderating. Price-to-earnings multiple compression could continue to offset rising profits. The Fed is intent on slowing growth to tame inflation, but has never engineered a soft landing when inflation is this hot. Meanwhile, the war in Ukraine is highly unpredictable, leaving open the possibility of further escalation. As such, we believe investors should focus on high quality, secular growth stocks. The market has rallied the past two weeks after investor sentiment had gotten excessively bearish on a short-term basis. However, the recent rally likely places the S&P 500 index at the upper-end of a trading range. We think the market may be susceptible to a retest of the lows.
We will continue to monitor risks including: (a) the potential for further escalation of the Ukraine conflict; (b) the possibility that China moves on Taiwan; and (c) the threat that spiking commodity prices and/or aggressive Fed tightening poses for the economy.
March 14, 2022
Similar to our last market highlight update, Russia’s invasion of Ukraine continues to displace Covid as the top of mind concern for investors. Russia’s invasion is likely a stagflationary event (lower global growth expectations at the same time as additional inflationary pressures) whose severity increases the longer it lasts – especially if it escalates.
The U.S. economy has gathered momentum: jobs and wages are growing, travel/leisure is recovering, retail sales are strong, housing is strong, autos are rebounding, capital spending is accelerating, and the rig count is rising. Unfortunately, inflation remains a big problem with wages, rents, and commodities all headed higher – the key will be the Federal Reserve’s (“Fed”) reaction function. Given the geopolitical development, it seems unlikely that the Fed will want to act in a way that further disrupts capital markets right now, despite the obvious need to fight inflation. We expect the Fed will continue to move slowly/cautiously as it initiates a tightening cycle due to the uncertainties related to Ukraine/Covid.
The market is likely to remain volatile and on the defensive until these geopolitical tensions ease and evidence emerges that inflation is moderating – as such we recommend focusing on high quality, secular growth stocks, where our clients are concentrated. Recession risk for now remains low, but is rising. We still expect growth in the economy and corporate profits in 2022 and S&P 500 EPS estimates have moved higher. Valuations are now more reasonable and investor sentiment has turned more bearish.
We will continue to monitor risks, including: further escalation of the Ukraine conflict and any attack on a NATO country; China moving on Taiwan; and spiking commodity prices and/or aggressive Fed tightening that throws the economy into recession.
February 28, 2022
Russia’s invasion of Ukraine has displaced Covid as the top of mind concern for investors, which is similar in its attendant human suffering, fear, and supply chain disruptions. Russia’s invasion is likely a stagflationary event (lower global growth expectations at the same time as additional inflationary pressures) whose severity increases the longer it lasts – especially if it escalates. The most direct impact for Americans will be felt at the gas pump and on the bread aisle.
Fortunately, the U.S. economy is gathering momentum as the Omicron variant recedes: jobs and wages are growing, travel/leisure is recovering, retail sales are strong, housing is strong, autos are rebounding, capital spending is accelerating, and the rig count is rising. Unfortunately, inflation remains a big problem with wages, rents, and commodities all headed higher – the key will be the Federal Reserve’s (“Fed”) reaction function. Given this new geopolitical development, it seems unlikely that the Fed will want to act in a way that further disrupts capital markets right now, despite the obvious need to fight inflation. We expect the Fed will move slowly/cautiously as it initiates a tightening cycle due to the uncertainties related to Ukraine/Covid.
The market is likely to remain volatile and on the defensive until these geopolitical tensions ease and evidence emerges that inflation is moderating – as such we recommend focusing on high quality, secular growth stocks, where our clients are concentrated. Recession risk for now remains low, but is rising. We still expect growth in the economy and corporate profits in 2022 and S&P 500 EPS estimates have moved higher. Valuations are now more reasonable and investor sentiment has turned more bearish.
We will continue to monitor risks, including: further escalation of the Ukraine conflict and any attack on a NATO country; China moving on Taiwan; and spiking commodity prices and/or aggressive Fed tightening that throws the economy into recession.
February 14, 2022
The economy appears to be reaccelerating now that we have emerged from the Omicron soft patch. Signs pointing to this reacceleration include: 1) plunging case counts, 2) falling jobless claims, 3) rebounding air travel, 4) rising oil prices, 5) rising copper prices, and 6) increasing bond yields.
Inflation continues to run hotter than expected, and many of the factors fueling it (money supply, wages, commodities, ongoing supply issues) don’t appear to be easing yet, ratcheting up the pressure on the Federal Reserve (“Fed”).
The Fed hasn’t even begun to tighten, but the market is already pricing in a significant amount of tightening, including a 93% chance of an initial +50 bps hike in the Fed Funds rate in March. The Fed is expected to be data dependent and therefore, inflation will be a key determinant on how aggressive it is forced to act. We expect the market to remain volatile and on the defensive until evidence emerges that inflation is moderating.
Inflation is also contributing to robust nominal GDP growth and profits, which are still forecasted to grow over the coming two years boosted by reopening, housing and auto production, and inventory replenishment. The consumer remains in great shape, but sentiment needs to improve so that today’s generally sour mood doesn’t begin to negatively impact spending.
Fourth quarter S&P 500 earnings per share are coming in slightly above expectations and estimates continue to get revised higher, albeit less meaningfully than in previous quarters. First quarter GDPNow is beginning to rise off its initial low estimate and should continue to rise as more data confirms that we have exited the soft patch. We still expect real GDP to grow somewhere between 3.5 – 4.0% in 2022, and corporate profits to increase by 8 – 10%. Meanwhile, stock market valuations have moderated since the start of the year, and investor sentiment has turned cautious.
We continue to actively monitor risks such as corporate margin pressures from rising input costs, the Fed acting too aggressively to slow the economy and subsequently increasing the risk of an early recession, onerous “Big Tech” regulatory or legislative constraints, geopolitical conflicts (Russia/Ukraine particularly in focus now; but also, China/Taiwan), and additional Covid disruptions that could once again impede the recovery.
February 2, 2022
The first month of the New Year got off to a volatile start, with both the S&P 500 and the Nasdaq experiencing their worst monthly declines since the March 2020 pandemic sell-off. This has primarily been a valuation correction on a hawkish Federal Reserve (“Fed”) pivot that has been most damaging to highly valued, speculative assets and resulted in rotation from growth to value stocks.
The lead-up to a bear market is typically marked by the following events: 1) the economy overheats, 2) the Fed overtightens, 3) the yield curve inverts, 4) and corporate profits peak. While it is probably safe to say the economy has overheated, judging by the fourth quarter combination of growth and inflation, the Fed hasn’t even begun to tighten – it will still be buying bonds for another month. However, the Fed has now signaled the possibility of a faster pace and magnitude of tightening compared to prior cycles, starting in March. The Fed will be data dependent, which means forthcoming inflation data will be highly determinative on how aggressive it is forced to act.
The economy and profits are still forecasted to grow over the coming two years, valuations have come down, and sentiment has turned more bearish, which should support the outlook for stocks. It is possible we may have seen a short-term oversold bottom last week, but we would expect the market to remain volatile and on the defensive until investors see inflation begin to retreat, which would then take some pressure off the Fed. We continue to favor high-quality, reasonably priced growth stocks that can sustain double-digit earnings growth in the year ahead.
The macro economic data over the past two weeks confirmed an Omicron soft patch. However, like the spike in cases, we expect this to be short lived. Fourth quarter real GDP +6.9% showed that the economy had a lot of momentum heading into Omicron. The Atlanta GDPNow indicates that the first quarter is off to a slow start, but should accelerate as cases recede.
Positive growth drivers in 2022 remain: global reopening, housing and auto rebound, and inventory replenishment. The U.S. consumer remains in great shape, but tough comparisons versus stimulus checks are still ahead. We still have another couple of big weeks of earnings reports ahead, but so far fourth quarter S&P 500 earnings are coming in slightly ahead of expectations. The magnitude of beats is beginning to normalize compared to what we’ve seen the past several quarters as growth naturally slows from the exaggerated early post-pandemic comparisons.
We continue to actively monitor risks such as corporate margin pressures from rising input costs, the Fed acting too aggressively to slow the economy and subsequently increasing the risk of an early recession, new “Big Tech” regulatory or legislative constraints, geopolitical conflicts (Russia/Ukraine; China/Taiwan), and additional Covid disruptions that could once again impede the recovery.
January 18, 2022
As we anticipated, macro-economic data points have begun to show evidence of an Omicron slowdown. However, we expect this to be short lived given that this variant appears to be peaking (or already peaked) in most major geographies, with very low fatality rates. Persistent red-hot inflation, a function of too much demand (extraordinary monetary and fiscal stimulus) and too little supply (Covid impact), has forced the Federal Reserve’s (“Fed”) hand to accelerate the taper, in addition to three (or more) possible rate hikes in 2022. The Fed pivot to fighting inflation is not risk-friendly, fueling a rotation from growth to value stocks since last November.
The 2022 market outlook hinges on how aggressively the Fed tightens, which in turn hinges on inflation. If inflation peaks and starts to come down, that would take the pressure off the Fed and reduce the risk of the Fed overdoing it.
The yield on the ten year U.S. treasury bond has quickly moved up 30 basis points to two year highs to start the new year; primarily a function of the 10 year TIPS (real yield) moving higher, while the market’s breakeven inflation expectation has held constant, a more reassuring sign for the economy.
Positive growth drivers in 2022 remain: global reopening, housing and auto rebound, and inventory replenishment. The U.S. consumer also remains in great shape and in position to power the economy forward – even in the face of less fiscal support – but lower inflation and less Covid is likely needed for confidence to rebound.
S&P 500 earnings estimates have suffered a setback in the past two weeks due to a weaker finish to 2021 and a slower start to 2022 caused by the Omicron spread. Investor sentiment is neutral with bullish sentiment down – likely due to the Fed’s hawkish pivot. Meanwhile, the Democrats’ legislative agenda has stalled on Capitol Hill, which reduces the likelihood of unfavorable new tax and spend policy until after the mid-term elections at least.
We continue to actively monitor risks such as corporate margin pressures from rising input costs, the Fed acting too aggressively to slow the economy and subsequently increasing the risk of an early recession, new “Big Tech” regulatory or legislative constraints, geopolitical conflicts (Russia/Ukraine; China/Taiwan), and additional Covid disruptions that could once again impede the recovery.
January 3, 2022
The Omicron variant is spreading rapidly, leading to spiking case counts, but fortunately very few fatalities. The South African experience suggests it should flame out quickly; widespread lockdowns are unlikely, but consumer caution likely tempers growth and extends supply chain disruptions similar to the Delta variant. The economy, however, has strong momentum and should be able to absorb another Covid slowdown.
There is a clear disconnect at present between strong economic growth (4Q GDPNow estimated +7.6% q/q annualized), low unemployment (+4.2%), high rates of inflation (CPI +6.8% y/y), and the Federal Funds rate at 0%. Persistent red-hot inflation, a function of too much demand (extraordinary monetary and fiscal stimulus) and too little supply (Covid impact), has forced the Federal Reserve’s (“Fed”) hand towards an accelerated taper and three possible rate hikes in 2022. While monetary policy remains highly accommodative, the Fed’s pivot towards fighting inflation is not risk-friendly. Central Bank bond purchases have clearly distorted bond yields, yet the 1.5% 10 Year Treasury yield seems to be signaling that the bond market fears that the Fed is likely to commit a policy mistake by panicking and slamming on the brakes.
We expect the economic expansion to continue in 2022 supported by global reopening, rebounds in housing and auto production, and inventory replenishment as supply chain issues get worked out. The US consumer also remains in great shape and in position to power the economy forward as confidence recovers. S&P 500 estimates have continued to move higher boosted by strong nominal growth, pricing power, and productivity gains; however, 4Q21 and 1Q22 estimates could get revised lower due to Omicron. Investor sentiment has improved, with bullish sentiment ticking lower following the Omicron news and the Fed pivot. Build Back Better was squelched and will require significant downsizing/reprioritizing to gain passage.
We continue to actively monitor risks such as margin pressures caused by rising input costs, the Fed committing a policy error by acting too aggressively to slow the economy and subsequently increasing the risk of a recession, new “Big Tech” regulatory or legislative constraints, geopolitical conflicts (Russia/Ukraine; China/Taiwan), and additional Covid disruptions that could once again impede the recovery.