Strategy and Positioning written by Steve Orr, Chief Investment Officer; and Essential Economics written by Mark Frears, Investment Advisor

As of market close May 20, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Powell push

Traders thought they had a Turnaround in play last Tuesday, pushed by Fed Chairman Powell’s comments at a Wall Street Journal symposium. The Chairman focused on the strong economy and, if activity did slow, the Fed would be flexible in how fast and how far it raised rates. Those encouraging words helped most U.S. indices post a 2% or better gain for the day. So far so good. 

April data released in the ensuing days painted a picture of a growing economy that is already slowing. Home construction, builder and manufacturing firms’ expectations all turned lower. A closer reading of Powell’s comments revealed that the Committee would be willing to raise rates “past neutral,” which would be above inflation. Recent inflation readings are running north of 8%, which would be a big jump from today’s 0.75% Federal Funds rate. Worries shifted back to just how far the Fed would increase rates, and combined with a number of inflation-driven earnings misses, brought out the Bears for the balance of the week. 

The S&P 500 has declined for seven straight weeks, falling 14%. Seven down weeks in a row is a rare occurrence, except for football fans in Austin. Bespoke Research found only four seven-week drops in the post-World War II period. The common thread to all four were concerns over the Fed tightening monetary policy (usually by raising rates) and possible recession. 

Street theme

“Peak inflation” is the popular narrative of the moment. Part of this argument relies on the fact that price increases should slow over the coming months because 1) several components, such as used cars, have rolled over and 2) smaller price increases later this year compared to last year’s big jumps. We were early adopters of this theme late last year. Unfortunately, continued supply chain problems continue to keep costs higher. 

Fuel costs are higher thanks to a difficult exploration environment. Uneven recovery around the globe is pressuring diesel fuel supplies. Walmart, Kroger and Target all cited higher delivery, fuel and labor costs and missed analysts’ earnings estimates. We expect retailer earnings to be marked lower over the next couple of quarters thanks to a rapid buildup of product inventories that will be marked down. 

Food costs in the coming months will also pressure prices. Ukraine is unable to get wheat onto ships and out through the Black Sea thanks to Russian warships. The government estimates that half of the usual crop will be planted this year. We are sure that number will change. India’s flip-flopping on wheat exports has also pushed prices to their highest in a decade. Here at home, Texas farmers will have few chances to benefit, as the drought in the Panhandle has wreaked havoc. “Most of them (wheat crops) will probably be totally abandoned…even up to 80 percent,” said Jackie Rudd, an A&M professor. Some Texas farmers do lock in prices this summer for delivery next year, so if the drought abates, they may see some relief in 2023.

Enough, already

After last week’s retail beating, we are glad earnings season is over. Usually when a company misses earnings estimates, traders punish the stock by pushing the share price down a percent or two. The company revises guidance and works with the analysts to get back in their good graces in subsequent quarters. Not last week. Walmart: down 11%, Ross Stores and Target: down 25%. Netflix, Dish, Amazon (!) and General Electric all fell by 10% on the day of their announcement. Almost sounds like a Memorial Day sale.

Despite the carnage in the retail sector, S&P 500 earnings fared well in the first quarter. 474 companies have reported through Friday, with 78% beating estimates. Earnings per share rose 11.1% over the first quarter of 2021, an above-average increase for this point in the business cycle. Top-line revenues increased 13.8%, also above average. 

China’s lockdown war against COVID will impact earnings and margins of companies doing business there this quarter. Taiwanese export orders fell 17% in April from March levels. A portion of their activity is with locked-down China, but their export orders are a bellwether for global activity. We will let the first quarter dust settle for a couple of weeks before putting a pencil to the second quarter. 

Poking the Bear

Last Thursday’s dip below 3,900 brought the S&P 500’s year-to-date drop within a percent of the 20% threshold for a Bear cycle. Down 17% for the year at this writing, the big index is still in correction mode. A global slowdown led by Chinese lockdowns, surging fuel prices and the Russian war has clouded the outlook for earnings. 

When traders are uncertain of earnings growth and future costs, they tend to push share prices too far to the downside. We think this “growth scare” may take the summer to resolve in either direction. Inflation and earnings growth may be peaking now and slowing later in the year. If so, the first five months of 2022 will go down as a “growth scare” that was just cooling off from 2021’s fast growth. 

Stepping back from the last four months, the S&P 500 has posted positive returns in 32 of the last 42 years and averaged at least a 12% drop during those up years. While 2022 is off to a rocky start, it is certainly not out of the norm.
 

2022 is also a midterm election year. Fiscal stimulus from Congress fades during these years and this one is no different. The average drop during midterm years is 21% versus today’s 17%. Despite a grinding correction, the Long-Term Bull is bent, but not broken. Of the nine midterms that went on to post negative returns for the entire year, seven were already in recession. 

Monthly stock options expired last Friday, taking a chunk of hedging gamma out of markets. Let’s see if daily volatility declines this week. With the major stock indices down anywhere from 5% to 9% and bonds about flat, there should be some rotation into stocks from rebalancing accounts toward month-end.