As of market close May 5, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Signs

May’s first week did not disappoint in the news category. Portfolio returns, however, did sag in response. The Fed stuck to its plan, the economy continued to slow, and banks dominated the headlines. 

Still on plan

Following market expectations, last Wednesday the FOMC raised the overnight Fed Funds target by ¼%. The increase marks the tenth increase since this cycle began fourteen months ago. This is the fastest rise in rates by the Fed in over thirty years. The Fed Funds target rate has run from 0% to ¼% to a range now of 5% to 5-¼%. Interest rate conditions became “tight” relative to history last December when the Fed Funds rate moved above the two-year Treasury, which yielded 3.9% last Friday. 

In raising by ¼%, the Committee is sticking to its plan from late last year of slowing the rate of increases. The Committee’s rationale in slower rate increases is to have it both ways: Be seen to fight inflation while not throttling the economy by moving rates too fast. The unanimous vote supported the Committee’s view that they are “strongly committed to returning inflation to its two percent objective.” The Fed acknowledged tighter financial conditions (tougher credit standards, higher rates and liquidity) are likely to weigh on the economy. Balance sheet reduction by letting Treasury and mortgage bonds mature will continue. Recent troubles in the banking system barely rated a mention. 

Depends

What about future rate increases? Wall Street has been pounding the “Pause” drum for weeks. Today’s press release set out several criteria the Committee will use to decide whether to raise rates further. They are: 

• Cumulative effects of the previous rate increases
• The lag effects of recent rate increases on the economy
• Economic and financial data

In non-economist terms the above list would read:

• Raising rates from 0% to 5% is slowing credit and growth in the economy, but we don’t know yet how badly.
• Each rate increase takes nine to 12 months to filter through the economy — so we have not yet seen the impacts of the increases that took rates from 3.5% to 5%. 
• Finally, GDP continues to slow and/or other areas of the economy run into trouble (commercial real estate mentioned a lot lately) or the economy (somehow) accelerates. 

Economy

The Fed remains fixated on job growth and wage inflation. Chairman Powell did acknowledge that wage inflation has moderated over the last several months. We have repeatedly pointed to WARN notices and jobless claims numbers as a forecast to coming job and unemployment numbers. The trend of both notices and claims suggests this summer will see rising unemployment. 

Last Friday’s jobs numbers are a case in point. The headline nonfarm payrolls job gain for April was 253,000, well above the 185,000 consensus. Net job growth above 200,000 is a sign of a healthy economy. But lifting up the hood, the job engine looks weary. Small business is the job creation engine of the U.S. Lacking good statistics from new businesses, the BLS estimates small business growth using a tool called the birth-death model. The name means new biz versus closing biz, not people. April’s birth-death estimate was 323,000 jobs, or well above the final number. In other words, other job categories shrank. 

Over the last six months birth-death has contributed a net 964,000 jobs to the 1.6 million total. That’s 57% of jobs gained. Nonfarm payrolls rose 2.3 million in the prior six-month period, from May through October 2022. Looking back into 2021, from November through April of 2022, payrolls rose 3.1 million. So, job growth is running at roughly half the rate of 18 months ago. Harder to quantify, but equally concerning is the rate of responses to the payroll survey. The number of companies participating has been on a five-year downtrend, clouding the picture for accurate results. Jobless claims continue to rise week over week but are nowhere near recession levels. 

Earnings 

First quarter earnings reports are on the downside now. Through last Friday, 419 S&P 500 names have reported. On the whole, earnings and revenues have come in above admittedly low expectations. Remember we started earnings season with Wall Street consensus earnings down -6.5% from 2022’s first quarter. After Apple’s good report, the index is tracking to a -2.2% decline. This will be the second quarterly decline in a row if results continue apace. 

FactSet reports that analysts still believe earnings growth will turn positive in the second half of this year. For the next three quarters, the consensus earnings change for the S&P 500 are -5.7%, +1.2% and 8.5%, for a full year increase of 1.2%. Let’s tally that up. War in Ukraine, increasing geopolitical tensions, inflation and interest rates at 20-year highs, and a 16-month Bear cycle. All this and earnings are just down roughly 13% from 2021 levels. 
 
Thirty-three S&P names report this week. Names we are watching include Dish Network, McKesson, Oxy Petroleum and Disney. Next week is big-box retail week: Home Depot, Target, TJ Maxx and finally Walmart on Thursday, May18. Walmart marks the unofficial end of earnings season, but we wait one more day for Deere on May19 to say goodbye to our favorite weeks of the quarter. One point of good news is that after earnings reports, companies can resume buying back shares of their stock. This does add some small measure of support to the market. 

Rates

We think the path of short-term rates has likely peaked for this cycle. Inflation will stick around the 5% to 6% range the next several months. The Fed’s goal of 2% is a long way away from today’s 5% level. Indeed, a return to 2% inflation in the next two years would mean the economy has downshifted into a serious recession. Futures markets are hedging a first rate cut as early as September. We think that is a bit optimistic and see the Fed sitting tight around 5% for most of 2023. 

The broad growth rate in prices, as measured by the Consumer Price Index, peaked last June at 9.1%. Wednesday’s CPI report should headline at 5%. No surprise, which would be unchanged from March. Goods and fuel prices have flattened or fallen over the last several months. Services and wages continue to edge higher. Lower rent levels from the fall are making their way into the CPI, but recent apartment data shows rents firming. 

Today’s 5% level remains well above the Fed’s 2% target. History encourages Wall Street’s view that the Fed should pause or stop raising rates. In the past, the Fed quit raising rates once the Fed Funds rate was above CPI. It appears that point may be reached later this year. 

Finally, last week’s headlines around banks are a bit baffling. Healthy banks with low levels of uninsured deposits got taken to the woodshed. Using the SPDR S&P Regional Banking ETF as a measuring stick, their stock prices are down some 40% from early February. Deposits left banks for money market funds in the 1970s, and again in the 1980s for S&Ls, so retail deposit movement is nothing new. Interbank deposits and credit lines with the Fed have fallen the last three weeks, suggesting little stress in the banking system. Stock prices for some banks look more like the meme stocks of 2021.