Average Overhead & Anticipation — Week of February 14, 2022

As of market close February 11, 2022. Returns in percent.

Strategy & Positioning - Steve Orr

• Events can shake markets – but rarely dent the long-term trend
• Higher gold, bonds and crude oil tell you traders are nervous about Ukraine
• Peaking: inflation and earnings growth?
• Fed Funds Futures projecting 1.75% by end of 2022 and 2.1% by end of 2023
• Earnings continue to improve

Average Overhead

One news headline is all it takes to ruin an otherwise good week. Last Friday’s admission by the White House that Russia was poised to (finally) invade Ukraine took the starch out of an otherwise solid week. Friday afternoon’s 2% to 4% drop across major markets was a classic flight to safety. Bonds gained anywhere from one-half to 1% on the day, pushing yields down by a tenth of a percent. The asset class of the week, or maybe the month, was gold. 

Gold futures' most recent peak was August 6, 2020, at $2,051. That was near the end of the second virus wave when stocks had just recovered their March/April losses, and 10-year Treasuries had bottomed at a half of 1% yield. Stocks continued to rally into the fall, and gold quickly lost its luster. The non-dividend paying metal shed 18% of its value over the next eight months. During that time the popular press derided the old standby as a “buy-gone” relic replaced by Bitcoin. Wars and threats of oil supply cuts have a way of making old new again. Gold broke out of a consolidating triangle pattern last Friday for the first time since its prior peak, rising 3%. We would like to see some other old-school ideas come back into fashion, starting with value stocks. 

Weather and geopolitical events tend to shake markets temporarily but not turn the long-term trend. At present the short and intermediate term trends for stocks are sideways. Any move higher in the near term will be met with strong resistance from moving averages. The quick drop in late January for the Dow Industrials, S&P 500 and NASDAQ, moved their spot levels below their 21-day (monthly) and 50-day moving averages. Small and mid-sized stocks are below their 200-day moving average, a warning for a possible trend change. We expect stocks to largely drift sideways under these moving averages until the Fed decides on a rate increase March 16th. 

Zig and Zag

Flight-to-safety havens are the bond market’s specialty. Short-term interest rates also fell Friday, including futures contracts briefly projecting fewer rate cuts. As news develops outside of market hours, do not be surprised to see rates move another tenth of a percent later in the week. 

This morning markets are better than even odds as to whether the Fed will raise overnight rates by one-half of a percent March 16th. Those odds for a half-percent increase have doubled from two weeks ago. Inflation is the primary driver of those concerns. We would add to those concerns an FOMC that cannot make up its mind. 

We must give the Fed credit. The members of the Open Market Committee are trying hard to communicate in plain language to the markets. This is a new trend in the history of the Fed. Unfortunately, messages get muddled or countered by different members. St. Louis Fed President James Bullard called for a 1% Fed Funds target by July, rattling markets Wednesday. Fellow members Barkin and Daly promptly came out against big increases. Markets are zigging and zagging because traders do not have clear direction and will not until at least mid-March.

Positioning

S&P 500 earnings continue to beat estimates. The 358 companies that have reported so far have improved earnings by 31% over the year ago quarter. Energy leads the way with a crazy improvement of 11,160% – remember much of the energy sector was losing money after virus shutdowns. Materials and Consumer Discretionary (autos) have risen a more understandable 65% and 52% over 2020’s fourth quarter. 

Our economy “Plus” column is much longer than our “Minus.” Yes, items do migrate from one to the other. We trust the Fed is too late to tame inflation. We recognize that components of inflation are either peaking or close to peaking. This behooves the Fed to be careful and deliberate and not move too fast. Rising rates will push New Orders, Business Confidence and Housing from Plus to Minus. Today our Minus column has only inflation, consumer confidence and central banks. The Pluses keep us fully invested but low on interest rate exposure.

Trendless markets waiting on central banks require patience. Planning is key and we are happy to review and update your plan as necessary. 

Essential Economics — Mark Frears

Anticipation

There are many things in life to look forward to. They can be life events like marriage, kids, grandkids, career moves, or smaller events like a long weekend, sporting event, dinner out with friends, a nice evening. We have expectations of how these will go, and they may or may not live up to the hype.

Prices

Last week the market was watching with bated breath for the Consumer Price Index (CPI) release on Thursday. As supply chain concerns and increasing prices are capturing the attention of consumers and markets, this was the next glimpse. The expectations are focused on the year-over-year (YoY) number, and this was 7% in December. In the past, the monthly change in core goods was the focus, but perspectives change, and the YoY is now the key. The release for January showed a 7.5% change, higher than the expected 7.3%, so the markets reacted strongly. Longer term rates on US Treasuries rose and stocks sold off, given the concern for higher rates in the future.

Managing expectations for economic releases is just as important as how you expect your next vacation to go. If a release comes in as consensus, there will be little movement in markets, yet if it is higher or lower, there can be ramifications. It’s all about your perception. This can be shaped by experience, friends, family or what you watch on your screen.         

Sentiment

What the future holds can be measured in many ways. While we have seen a significant move up in current UST rates, the expectations for five years from now have not changed materially. They expect this inflation bump to be contained and/or trend back down.

The University of Michigan monthly consumer sentiment is another measure of what people are thinking. The preliminary overall reading for February came in at 61.7, down from 67.3 last month.  People are concerned about what they are hearing. There is also an inflation expectations piece of this survey and it showed one- and five-year levels unchanged. The future still looks very good. 

FOMC

The Federal Open Market Committee is in the cross-hairs as to their next moves. They have two-fold responsibility for full employment and keeping inflation in check. Based on the unemployment rate and plentiful jobs available, they are focused on controlling inflation. The Fed’s primary tool to combat inflation is raising the overnight target rate for borrowing. They do not control UST rates, but the expectations of what they are going to do have a huge impact on the longer-term market.

Futures markets for this overnight target rate now show the FOMC moving this rate up approximately 1.72% by December 2022. The FOMC operates in a mode where it does not want to disrupt markets, so it usually moves at a gradual pace. So, they need to demonstrate to the markets and consumers that they will raise rates enough to control inflation, while not slowing the economy too much. This is a difficult line to walk. We will get some clues as to their next move when we review the minutes from their January meeting on Wednesday this week, but the next FOMC meeting is not until March 15-16. There will be an incredible amount of expectation leading up to that meeting, and it is the FOMC’s responsibility to manage that expectation.

Wrap-Up

I try to keep my expectations managed properly, not too high, not too low. Of course, this is not always possible, as hope springs eternal! Right now, given what we know about improving supply chains, and prices peaking, the market’s expectations for the FOMC have ramped up too far, too fast. 
 

Mark Frears is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Science from The University of Washington, and an MBA from University of Texas – Dallas.

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. 

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