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

index	wtd	ytd	1-year	3-year	5-year	index level
S&P 500 Index	6.19	-6.05	15.58	18.35	15.46	4,463.12
Dow Jones Industrial Average	5.53	-3.89	7.74	12.72	13.16	34,754.93
Russell 2000 Small Cap	5.43	-6.87	-7.07	11.64	9.79	2,086.14
NASDAQ Composite	8.20	-11.05	6.66	22.71	19.83	13,893.84
MSCI Europe, Australasia & Far East	5.28	-7.46	-1.52	7.26	6.92	2,149.68
MSCI Emerging Markets	3.32	-8.77	-14.76	4.21	5.77	1,120.93
Barclays U.S. Aggregate Bond Index	-0.68	-5.44	-3.36	2.27	2.38	2,227.03
Merrill Lynch Intermediate Municipal	-0.55	-4.80	-3.15	1.92	2.58	304.73

As of market close March 18, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

 

• New tightening cycle begins with quarter-point increase
• Fed surprises with forecast of nine increases to between 2.5% and 3%
• Retail Sales keeping pace with inflation, home sales falling due to no inventory
• Stock correction continues 

The Ides

Certainty or at least less uncertainty cheers markets. Most of this year’s crummy start can be blamed on when and how much the Fed will act to combat inflation. We were ahead of the crowd in asking for rate increases last year, and firmly believe the Fed, once again, is late. Some Fed certainty and prospects for ending Russia’s invasion of Ukraine took stock index volatility, crude oil, the dollar and gold off their recent highs. 

Stocks took the hint on the Ides and the major indices piled on 5% or better gains for the week. It marked the best week of the year and a welcome break from the ten-week downtrend. The rally sent prices above 21- and 50-day moving averages for the first time in at least two months. As the table above shows, small and midcap stock indices performed better than their tech-heavy big brothers. 

While a rally week is nice, we are still in correction mode and the Bulls bear the burden of proving any turn positive is durable. The charts have a number of resistance levels that need to be punched through and internals such as new highs vs new lows, breadth, and percentage of stocks above their averages have a way to go. History also reminds us that mid-term election years usually do not turn positive until summer. Patience. 

Fed Surprise

As expected, the Federal Reserve Open Market Committee raised its target overnight funds rate by one-quarter of a percent last week. The Fed’s statement recognized that energy and other price pressures are keeping inflation “elevated.” The statement also cited the war in Ukraine as a factor “likely to create additional upward pressure on inflation and weigh on economic activity.” For the first time, the pandemic was not listed as a factor. The Fed pledged “ongoing (rate) increases” to attack the highest inflation rates seen in 40 years.

Increasing interest rates hurts main street interest payers, while helping savers. Reducing the Fed’s bond holdings pulls funds from the banking system, which hurts Wall Street. The Committee will be using both tools to combat inflation. We would note that the economy was already downshifting to slower growth. But, and this is important, the 2.8% growth projected by the Fed this year is still nearly double the 1.5% growth experienced over the last decade.

Since Chairman Powell had telegraphed the quarter-point rate increase in earlier testimony, traders were focused on the Committee’s interest rate (the “Dot Plot”) and economic projections. To Wall Street’s surprise, the FOMC projected six quarter-point increases this year and three next year. According to the Fed’s projections, by the middle of 2023 short-term rates would be somewhere between 2.5% and 3%, back to October 2019 levels. At least traders are certain the Fed is serious about inflation. Futures contracts are pricing in a better-than-even chance that the May 4th meeting will see a half-percent increase. Based on Chairman Powell’s statements, we expect the Fed will announce its balance sheet reduction plans then. Letting Treasury and mortgage bonds mature and only re-investing the interest payments are a reasonable path.

Another Inflation

Wars can cause inflation and where it hurts the most: food prices. The Russian invasion is no different. Lost in the noise this year is that grain prices began rising shortly after Labor Day last year. Why? Low yields around the globe, mostly due to drought. This week should mark the start of corn planting for Ukraine. Despite most of the country’s crop farming being in the more-quiet west, we doubt many farmers will be planting. 

The “it doesn’t matter” crowd point out that Ukraine and Russia together are barely 2% of the world’s economy. That is true as a statistic. Their wheat and corn exports feed much of the Middle East and Northern Africa. Recall that the 2009 Arab Spring overthrow of governments started with high grain prices from droughts. Ukraine and Russia’s wheat and corn exports represent 10% and 15% of the world market. Ukraine’s sunflower oil production is 50% of the global supply. If rents and home prices are this year’s factor in keeping inflation “higher for longer,” then food may be next year’s. 

Wheat, Corn and Cotton futures all at decade highs:

Source:  Refinitiv Workspace

Earnings growth this year for the S&P 500 continues to hover around 11%. Margins and revenues are record levels. Interest rates are moving higher, but monetary conditions will remain easy well into 2023. Companies have refunded high interest debt and have lowered their cost of capital. The path of inflation and the Fed’s reaction are key at this point to earnings and valuations. We expect inflation rates to moderate in the second half of the year. Three months ago, we figured year-end inflation at 3.5%; with the war and food inflation on the horizon, 4.5% is more plausible.

A Comment 

One more comment on Russia’s invasion of Ukraine. A big picture view of the Russian strategy shows the initial plan failed. Plan two is classic Russian doctrine: shell until nothing is left. In his attempt to rebuild the Russian Empire, Putin has achieved two of the three stated goals: 1) keep Ukraine out of NATO – Zelensky has said as much, and 2) build a land bridge down the coast to Crimea. The third objective, capturing Odessa and thus controlling Ukraine’s export economy, may be within reach. Japan reported last week that Russian amphibious assault ships had sailed south. Presumably, they will join up with other naval assets near Odessa in the Sea of Azov. 

One of Sun Tzu’s dictums was “always leave your enemy a golden bridge.” In other words, a way out with honor, or looking like he won. Perhaps markets sense that Putin is stringing talks out long enough to have a way out without taking over the entire country. He could declare victory and achieve three economic objectives.

 

 Essential Economics

 — Mark Frears

 

Choices

When is having too many choices a bad thing? Have you seen how many options there are for paint colors?! It takes up a whole section at Lowe’s, and do you really need 36 shades of blue? The painting of a bedroom takes less time than the time spent choosing the paint color. This week we had lots of choices on economic releases from multiple perspectives, but the market’s eyes were on the FOMC and the war in Ukraine.

Retail Sales

The consumer was not as active in February, as this metric came in below expectations. The strongest sector was Gas Stations, at up over 5%; if it were not for this sector, overall sales would have been down 0.2%. The reopening trend continues as restaurants experienced higher sales than one year previously. The process of people buying more services than goods will continue even with labor and supply constraints. Given the new Covid lockdowns in China, the supply chain could slow again.

We need to look at this on a year-over-year basis, as that is the view on inflation we are watching lately. Retail sales on a y-o-y basis are up over 17%, very good news. The caveat is that more than half of that is because of inflation. After taking out inflation, February’s number was still higher than any pre-Covid readings.

From a business perspective, this is great news, if they can find products to sell and people to work. 

Business

Industrial production was up slightly in February with Manufacturing output increased 1.2 percent after little change the previous two months. This index has advanced 4.2% since January 2021, still on an uptrend.

Housing

There is still very strong demand for housing, despite lower supply and rising mortgage rates. Housing starts were up almost 7% in February to an annualized rate of 1,769,000 homes. This is the highest level since June 2006. Building permits were down slightly for the month, coming off a 16-year high in January.

Existing home sales fell 4.5% from a month earlier due to higher home prices, rising mortgage rates and cold weather.

Looking ahead

U.S. leading index rose 0.3% in February following a sharp drop in January. The LEI is a weighted gauge of ten indicators designed to signal business-cycle peaks and valleys. Thursday’s S&P Purchasing Manager surveys should shed light on how businesses are bouncing back from omicron.