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

As of market close May 6, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

5 and 10

The S&P 500 notched its fifth week in a row of losses, thanks to more Powell Pain and a growing Wall of Worry. The big index and its mid- and small-cap brothers are all down 10% over those five weeks. Despite growth-oriented tech stocks making up the largest portion of the index, the value and defensive sectors have held up the main index. Utilities, consumer staples and materials are down substantially less than the averages. The star this year remains companies in the energy sector, up 49%. That is due more to supply shortages and reopening than an ongoing war premium. 

The Nasdaq is 16% lower over that time frame and emerging markets are 12% lower. There are parts of the Nasdaq where one does not go without protective gear. About half of the index’s stocks are down at least 50% from their highs. Nearly 10% are down over 80%. Year-to-date, every major index except Large Cap Value ( -6.6%) is in correction mode. 

What stands out to us in this correction is the intra-day volatility. Most corrections have two or three 1/2 or 1% down days as their “big events,” sprinkled over weeks of trading. Since April 22, the S&P 500 has experienced four days of at least a 2% move to the close. One of the drivers is dealer hedging of clients’ option positions. But moves of this size usually mark a capitulation or “blow off” phase where the last of the speculators throws in the towel. Instead, these big moves have been marked by fairly normal ratios of selling and buying. Volatility and breadth measures are slightly elevated but also not near capitulation levels. The weight of the technical evidence suggests more bumps ahead. 

Over 20!

Breathless headlines announced last Wednesday’s rate increase by the Fed as the largest in 20 years! Yes, the half-point increase was a “big” jump. Since inflation has been mired in wonderful disinflation, falling for nearly 40 years, the Fed has been able to nibble rates back and forth in tiny bites. In the nineties the Greenspan Fed used three-quarters of a point changes with regularity. Paul Volker remains the king of increases. Deputized by President Carter to attack (real) inflation soaring into the teens, he led the Fed from 1979 into 1987. Volker knew that interest rates were far below inflation and had to rise to choke it off. Volker pushed through increases greater than 2% seven times from 1979 into early 1982 to get inflation under control. The biggest? A 5% whale in March of 1980, followed by a 4% increase in May of 1981. The risk, of course, was that high inflation and interest rates would tip the economy into recession. It did and made it tough for us recent graduates in the job market.  

One could easily conclude that Mr. Volker was serious about tackling inflation. Chairman Powell has invoked Mr. Volker twice in recent speeches. Yet last Wednesday the FOMC voted for just a ½% increase. Granted, they had well telegraphed the move. But their rhetoric leading up to the meeting was quite hawkish and had traders very nervous about how far and how fast the Fed would move. In his press conference, Chair Powell intimated that three-quarters of a point increases were likely not to be on the table. Atlanta Fed President Bostic said this morning that the Fed does not need to move faster than ½% steps. In other words, the Fed will move very slowly to attack inflation. 

The Plan

The other shoe to drop last Wednesday was the Fed’s Quantitative Tightening plan. Letting bonds mature out of their portfolio pulls liquidity from the banking system. Wall Street was prepared for at least $1.1 trillion in runoff starting in June and was prepared for a higher number. They got the bottom-end $1.1, but with a leisurely three-month ramp up to that number. Over four years this reduction in liquidity should have a similar impact on the economy as a 2% rate increase. So that is 1% per year. Hardly threatening to the economy. 

Walls

Markets climb a wall of worry, goes the old adage. The Fed’s raising rates too far / too fast may be turning to a more serious worry of too slow. The Russian war is going to drag on much longer than we anticipated. China remains all but closed due to port area lockdowns. We think their reopening efforts will include a massive spending program to get their economy back on track. 

Lack of trade and shipments crimps supply. Unless inflation further curbs demand, be prepared for higher prices for longer thanks to a new round of supply chain headaches. We are impressed with the number of companies reporting that supply chains are less of a problem. Here’s to continued improvement. 

Interest rates have scaled their own recovery wall over the last several months. Most sectors are at or near their pre-pandemic highs. Some areas of the bond market, particularly municipals, represent value at these levels. We believe much of the rate move is complete and if the economy does moderate in the coming months, more sectors will become interesting to us. Regardless, we welcome the higher levels as bonds can now generate more meaningful income.