Investment Strategy

Markets are up—but should they be?

The Fed is starting to apply pressure, but consumer spending hasn’t slowed (yet).

Our Top Market Takeaways for March 25, 2022.

Market update

Perplexing Rally 

 

The equity market keeps rallying, and nobody really knows why. Heading into Friday trading, the S&P 500 has tacked on another +1.3% to its torrid rally from last week. The Nasdaq 100 added another +2.5%, while Europe is about flat.

This is despite the most hawkish version of Jerome Powell yet (see his economic outlook speech from Monday, when he suggested the Federal Reserve would not hesitate to move monetary policy to territory that would actively slow the economy), bond yields across the curve soaring (2-year U.S. Treasury yields are almost 20 basis points (bps) higher over this week, and 30-year Treasuries are near cycle highs), continued volatility in energy markets (WTI crude is back above $110 per barrel), and no clarity in Russia’s horrific war against Ukraine. 

Here are some possible reasons why the S&P 500 is up almost 8% over the last eight trading days.

  • Investors had just gotten too negative. Worrying about nuclear war, oil rationing and impending recession all at once results in lower equity prices. The relative lack of any material new news is better at the margin.
  • The equity market is calling the Fed’s bluff. The stock market doesn’t think the Fed will actually go through with its plan to raise the policy rate to 2.75% by the end of 2023.
  • The equity market actually had something worse from the Fed in mind. There is no way of actually proving this, but it is notable that ARKK (here, a proxy for a basket of potentially high-growth but speculative companies – one of the cohorts most sensitive to tighter policy) is up 30% since last week’s lows, while the Nasdaq 100 (likewise theoretically hurt by higher interest rates) is up almost 13%.

But for long-term investors, the reasons for the rally over the last few days are less important than the perplexing set of headwinds and tailwinds for the U.S. economy and markets that are clouding the medium-term outlook.

Coming in to the year, it seemed to us as if the tailwinds had a clear advantage, but the Fed’s plans for an aggressive tightening cycle have evened up the match.

To help assess where we might be heading, we broke the U.S. economy into four cohorts: the Fed, Wall Street, Main Street and the C-Suite.

Spotlight

The Fed, Wall Street, Main Street and the C-Suite


[1] The Fed
is embarking on an aggressive rate hiking cycle that has the stated goal of “Restoring Price Stability” (i.e., getting inflation down).

At this point, markets are priced for another 175-200 bps of rate hikes this year, which means that we are likely in for a 50 bps rate hike or two at some point. This hiking cycle will resemble the 1994 experience (when the Fed raised rates by 250 bps in a calendar year, with two 50 bps moves and one 75 bps monster hike in November) much more closely than the relatively gentle cycle of the late 2010s.

This chart shows the fed funds rate from 2016 to March 2022, then the market expectations through year-end. Throughout 2016, the fed funds rate was at a low of 0.4%. Acting as a step function, it jumped eight times to land at 2.4% by February 2019. At this point, it fell to 1.6% by October 2019, and 0.13% by March 2020. It held firm at this rate until March 2022, when it hiked 25 basis points. Going forward, the market expects an aggressive hiking cycle: to 1.3% by July 2022 and 2.1% by November 2022. The median fed dot based on the March FOMC meeting places the year-end 2022 rate at 1.875%.

[2] Wall Street is convinced that something in the economy is bound to break. Between higher rates, higher inflation and higher gas prices (the thinking goes), there is no way the consumer will be able to keep the pace.

By many frameworks, rates are already at levels that should be cooling the economy. Mortgages are back above 4.5%, where they were in 2019 when the housing market cracked. The slowdown is likely to show up in housing first.

This chart shows the 30-year fixed mortgage rate and its 5-year moving average, from June 13, 2003, to March 18, 2022. The first data point came in at 4.9% in June 13, 2003. Here, it climbed to 6.1% before declining to 5.1% by March 12, 2004. From there, it rose to 6.1% by May 14, 2004, before declining once more to 5.1% by June 3, 2005. Here, it rose to a peak of 6.4% by July 7, 2006, before it declined to 5.6% and then rose back up to 6.4% on June 15, 2007. From here, it declined before rising back to 6.4% by August 8, 2008. From there, it declined to a trough of 3.4% by December 28, 2012. Here, it rose to 4.6% by July 5, 2013. Then, it declined to 3.3% by September 30, 2016. Here, it rose to 4.2% by March 10, 2017, before declining to 3.4% by September 8, 2017. From there, it rose to a peak of 4.8% by November 9, 2018. Then, it dropped to 3.6% before climbing to 4.1% by March 13, 2020. Here, it dropped to an all-time low of 2.9% by February 12, 2021. From there until recently, it rose to 4.6% by March 18, 2022. The 5-year moving average came in at 6.8% on June 27, 2003. From here, it declined to 5.6% by June 1, 2007. Then, it declined even more to 3.9% by December 16, 2016. From there until recently, it declined to 3.7% by March 11, 2022.

Most of the U.S. Treasury yield curve is flat or even inverted, and the money markets are already pricing in interest rate cuts in late 2023. This suggests that bond managers don’t think the economy can tolerate the hiking cycle the Fed has in mind.

Equity managers are holding their highest allocations to cash since April 2020, and close to 70% of managers expect weaker economic growth going forward, the most since October 2008.   

[3] Main Street is frustrated by the economy, but it hasn’t noticeably changed its behavior. At least not yet. Consumer sentiment surveys have been at recessionary levels for months, but card-spending data and retail sales are still robust.  

A record low number of survey respondents think now is a good time to buy a house, but they are still consistently paying above the asking price for homes. While mortgage rates should be pinching the housing market, real-time demand indicators are surprisingly strong. However, given the rise in mortgage rates, new mortgage applications and home sales data should soften going forward. 

This chart shows the U.S. average sale-to-list (SA) and residential inventory from 2012 to January 2022. The average sale to list began at 96.2% and climbed to 97.6% in August 2013. It remained relatively stable at 97.3% until October 2014, then it started steadily rising. It reached 98.4% by June 2018, dipped to 98.1% in August 2019. It spiked to 98.7% in February 2020, then dipped. It then skyrocketed to 101.8% by June 2021, fell to 100.6% by September 2021, then rallied to 101.6% by January 2022. Meanwhile, inventory began at 2,189 and fell to 1,844 by April 2013. By July 2014, at 1,966, it began falling to 1,479 by January 2018. It then rallied slightly before falling again to a series low of 718 by January 2022.

The only thing record-high gas prices are good for is local news correspondents who need segment ideas, but Americans are still hitting the road. Data from gas savings app GasBuddy suggests that demand for gasoline actually hit a pandemic-era high in the same week that gas prices did. It doesn’t seem like we are at a point where gas prices are causing demand destruction. At least not yet.

Finally, pent-up demand still does seem to exist for travel and services that were disrupted by COVID-19. Look no further than Fabulous Las Vegas. Card spending on the strip is 35%–40% above 2019 levels. Casino operators from MGM to Caesars to Wynn have been impressed with recent demand, and are expecting a continued travel boom through the spring and into the summer.  

[4] The C-Suite seems almost apologetic for how good its results have been. Next 12-month earnings expectations for the S&P 500 have actually climbed this year as consumer and corporate demand has come through. While the C-Suite seems wary of a consumer slowdown coming, it hasn’t seen it. At least not yet.

Nike, Lennar (a homebuilder), Home Depot and Disney have all recently offered upbeat forward-looking commentary. While corporate earnings may be the last place a consumer slowdown may show up, it is still notable that most management teams seem pleasantly surprised by the durability of demand.

Investment takeaways

When uncertainty is high, simplify


The Fed is going to antagonize markets this year, and Wall Street is convinced the economy is going to slow. However, consumption and corporate confidence is still high. Investors are uncertain about whether the headwinds or tailwinds will prevail, and the recent volatility is indicative of the controversy.

Here are the simple descriptions of where we stand, and what we are doing about it.

The Fed: Expect an aggressive hiking cycle until inflation rolls over. The most likely outcome for the economy is a “soft-ish” landing, but risks have risen.

  • Investment implication: We are refocusing on core fixed income, especially now that a historic selloff in municipal bonds is providing an entry point.

Wall Street: It’s hard not to see a volatile, range-bound equity market in the near term, but some pockets could be set to outperform.

  • Investment implication: The megatrend of digital transformation is still gaining momentum, and valuations have corrected materially. We think technology stocks seem attractive.

Main Street: Housing and durable goods consumption are likely to cool, but services spending could be more resilient.

  • Investment implication: If growth does slow down, the consumer will likely be the cause. We are watching the housing market, services sector spending, and credit card utilization for signs of consumer stress.

The C-Suite: Higher-quality firms with secular drivers and strong management teams should outperform. 

  • Investment implication: We think high-quality businesses trading at a discount to the market could provide a haven while uncertainty prevails.

 

Above all, creating a plan and sticking with it are the best ways for investors to maintain control and confidence when the range of possible outcomes is wide.

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