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

As of market close February 25, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

• Events like regional wars are unfortunate but do not change long-term trends
• Wage inflation is a symptom of labor supply, not a reinforcement to inflation
• Housing activity is off its peak – responding to higher inflation
• February economic activity bouncing back from omicron restrictions

Events, Not Trends

The correction from recent highs started with Fed uncertainty. The winds of war added fuel over the last two weeks. In the uncertainty, stock indices have likely overshot to the downside. Markets have now begun to discount the depth of the global impact of Russia’s takeover of Ukraine. Not to diminish the suffering of the Ukrainian people, but our stock markets look ahead and assess possible impacts on earnings by conflicts. Regional or country-specific conflicts historically do not impact earnings in the U.S. We think in the coming weeks markets will turn their focus back to the Fed and earnings. 

Two weeks ago, we looked at 33 conflict events dating to World War I. Only five saw stock index returns lower six months later. Four of those five occurred in World War I. The fifth was after the Iraqi invasion of Kuwait, when our economy was already in recession. The U.S. came out of that recession less than three months later, and stocks rallied 20%, hitting new highs during that three-month period. In 1962, the Cuban Missile Crisis pushed stocks down 22% in three months. Over the following year, stocks moved to new all-time highs. Events rattle markets but rarely, if ever, change the long-term trend. 

The current short-term trend is down, and stocks sit in correction territory across the board. Mega-cap tech and growth names have taken the biggest hits. They were the biggest beneficiaries of the easy money policies of the central banks during the pandemic. This is because their share prices are calculated by dividing a growing cash flow by ever-lower interest rates. As central banks start to raise rates, that denominator rises, striking fear into momentum traders. 

On a weekly to monthly horizon, stocks are consolidating and may have put in their lows. Like recessions, you do not know you have put in the lows until well afterward. One consistent rule of thumb in corrections is that your first low is rarely your last, and the correction usually does not shift into consolidation until you test the low again. Back on January 24^th, we thought the first low was in when the S&P 500 dropped to 4,222 during the day. Last Wednesday’s pre-invasion sell-off sent the S&P 500 right back down to 4,221.5. Is that the test of the low? After all, Thursday and Friday saw the averages rise between 3% and 5%. Again, we cannot be sure until more time has passed, but we think the evidence leans toward this correction’s lows are in. 
 

Parallel Tracks

Our charts continue to suggest a time consolidation ahead, with stocks bouncing back and forth in a roughly 8% range. Fed Chairman Powell testifies before Congress Wednesday and Thursday; his statement will be released Tuesday. Last week we expected his remarks to focus on how inflation has spread to all areas of the economy. This week we expect he will add some remarks about the international banking system as it relates to Russian sanctions. 

One series we are watching closely is wage inflation. This Friday’s January employment report should show average hourly earnings growing at a 6% annual clip. While that is close to consumer price inflation at 7.5%, wages have not kept up for a decade. 

There is a line of thought that wage inflation leads to more inflation. We are skeptical. Rising wages are a response from employers to a supply problem. There are still a significant number of workers staying away from work due to childcare, caring for family, etc. During inflation periods, higher wages are depleted on higher gas, food and rent. While wage inflation and inflation are traveling on parallel tracks now, we do not see them reinforcing each other. 

A Reminder

Events tend to push stocks far to the downside. In most cases the ensuing months produce good buying opportunities. Earnings and margins are at record highs. Corporate and consumer balance sheets are in very good shape. The economy is prudently downshifting from extremely fast to solid growth this year. The probability of a recession is very low. The Fed moving too far, too fast raising rates would set the economy on a recession path after 2023.  

The correction has restored stock valuations to reasonable levels, and sentiment remains very bearish – a bullish sign. Interest rates are going to tread water until March 16th. Commodities, especially oil and wheat, will enjoy an additional war premium through the summer. Russia is also a big exporter of low-grade steel, platinum and rhodium. These are valuable metals in the construction and electronics industries. Several of our indicators have moved from bright green to green or neutral. They are telling us to be patient.

 Essential Economics

 — Mark Frears

Home Sweet Home

It is good to have a place to call home, especially in these turbulent times. The question I have for you this week is, can you fit your car in your garage? During times of winter weather, and in the upcoming hail season, it is important to me to get the cars in the garage! Maybe you have too much stuff, or too many cars to do this. Maybe you need a bigger house or need to make home improvements. Your home is your castle and what you do with it is a big deal to you, and the economy.

Owner

If you currently own a home, you have seen the value of your abode increase, perhaps dramatically. U.S. home prices increased 18.8% over 2021, the highest level in 34 years, per the Case-Schiller index. Given that mortgage rates are moving up slightly from historically low levels, you probably financed this purchase at a very reasonable level, too. 

You are also contributing to a very significant sector of the economy. The housing market represents 40% of core Consumer Price Index, almost a fifth of GDP and a considerable part of household wealth.  

How are you feeling about your home? Do you want to move? You could get a good price for that building, but where would you buy? It is a seller’s market. Does the higher value make you feel more comfortable about making improvements to the homestead?

Earnings and revenues at Home Depot and Lowe’s are up as people make those modifications to be even more comfortable.

Buyer

If you are in the market for a home, you might be frustrated. You bid on a house and were one of ten potential buyers, but because you did not want to go THAT far above the asking price, you did not get it. At the same time, mortgage rates are rising, perhaps making that home purchase out of your budget.

On the positive side, consumer balance sheets are in great shape, employment opportunities are strong, and wages are growing. This month we saw Consumer Spending up 2.1%, more geared towards durable goods like cars, versus services. As COVID restrictions continue to abate, the previously constrained consumer is ready to spend.

On the employment front, we saw Continuing Unemployment Claims drop to their lowest level since the pandemic. Workers are back at work.     

While the consumer is in great shape and the underlying economy looks very good, two things could hold the consumer back. First, confidence levels are falling. The University of Michigan Consumer Sentiment fell to the lowest level since October 2011. The primary drivers here were lower confidence in the government’s economic policies and rising interest rates. Geopolitical risks should add to the growing lack of confidence. Second, inflation is reducing the purchasing power for you and me. As we go to the grocery store, gas station or home improvement store, we find that our dollars don’t buy as much as they did last year. 

The Fed is committed to raising rates to fight inflation. What they can’t control are supply chain issues that are not allowing products to get to market and, therefore, increasing the costs. We have seen good signs of improving flow of goods that should lessen the inflationary trend later this year. The demand for housing is still strong. People want to buy a home and enjoy the benefits.

Builder

The home builders are working hard to bring more supply to the picture. They see the pent-up demand for homes and are working hard to resolve worker and supply issues, especially as mortgage rates start to creep up. Building Permits and Housing Starts releases showed a slowdown in January, but as we head into the spring buying season, they should pick back up. 

There is an additional opportunity here for builders, as Existing Home Sales are expected to flatten out in early 2022 and remain flat for the year.

U.S. Business Investment continues to advance. Last month, core orders grew 0.9%, and core shipments grew by 1.9%. These are both strong indicators that companies are healthy and growing. As they prosper, their employees do better, and will be looking for that next home.