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

As of market close April 8, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

• Weak start to the new quarter; higher interest rates tough on stocks and bonds
• Economy remains strong — jobless claims 40-year low
• But new orders and inventories suggest slowdown ahead
• Fed plans $95 billion per month balance sheet reduction — more aggressive than expected

Pulling Down 

The new quarter started poorly last week. Most indices fell between 1% and 6%. The Dow Transports brought up the rear, pulled to earth by Jet Blue (-18%) and ocean shipper Matson. Analysts did not like JetBlue’s takeover bid for Spirit. Matson did not print any news recently, but the stock had run up sharply over the last month. 

Small cap and the tech sector also trailed, falling nearly 4%. Higher funding costs get the blame for both sectors. Healthcare, energy and consumer staples continue to do relatively well. All rose at least 2.5% last week. Much of the volatility this year centers on whether the Fed will be successful in its efforts to contain inflation. How far will the Fed raise rates and how fast? How much will the Fed reduce its balance sheet? 

Inflation is already hurting activity. Gasoline volume and big-ticket purchases are down month-over-month. Higher mortgage rates are starting to hit the housing market. Headline inflation should moderate in the coming months thanks to easier year-over-year comparisons. However, our 3.5% growth and 3.5% inflation forecasts from the beginning of the year need to be pulled down.

Still Growing 

We expected growth would slow this year from last year’s pandemic rebound 7% level. The $4 trillion of new dollars added to the monetary system would keep things moving but could also spark inflation. The combination of pandemic waves causing additional shutdowns, already low energy supplies and a war in the global breadbasket will keep prices “higher for longer.” If higher prices stick through the fall, GDP growth could fall another 1% and inflation could average 1.5% to 2% higher by the end of the year. So, pencil in GDP at 2.5% and inflation to end the year closer to 5%. 

Why no greater drop in the inflation rate? Food and energy are “core goods” for most of us. The economists at the Bureau of Labor Statistics think the opposite. Tuesday the BLS will release the Consumer Price Index and Wednesday the Producer Price Index for March. Both remain elevated thanks to fuel prices. Expect CPI to show an 8.5% gain over last year and PPI a near 11% gain. 

Food prices will play a role later in the year. Ukraine’s wheat crop will be at least one-third lower than expected thanks to the war. It will matter little, because there is no way to get the grain to port or to other countries. Egypt relies on Ukraine for half of its wheat. Protests in Peru over food prices have led to at least six deaths in the last 10 days. Remember 2009’s Arab Spring protests started with high food prices for wheat and bread. 

Lower but Better

The market’s “happy weeks” are here again. Markets tend to perform better during the seven weeks of earnings season than the roughly seven weeks without earnings reports. This Wednesday marks the unofficial start of earnings reports for the first quarter. As usual, the big banks will lead off. Citi, Goldman Sachs and JP Morgan Chase all report. Analysts will be watching for whether investment banking deals have been sidelined by the war, consumer spending and loan volume. Citi does have a Russian presence, so their management call will get additional scrutiny. 

Expectations are for all S&P 500 companies to grow earnings about 5% over 2021’s first quarter. According to FactSet, over the last five years, companies have beat estimates by about 8%. If that beat rate holds for the first quarter, earnings growth would be 13%, an impressive feat in the face of inflation, supply chain (Shanghai) and war constraints. 

The key for earnings season is what management thinks about their orders and activity for the rest of the year. ISM New Orders index has flattened out and the Inventories index is rising. That is not positive for earnings. Consumer sentiment is falling thanks to inflation. Eric Johnson at Cantor pointed out recently that high Producer Price Inflation correlates very well with manufacturing 12 months later. That’s a fancy way of saying that high production costs lead to lower production levels a year later. What does management think about their supply chains, reshoring, replacing jobs with machines, etc.? 

 Essential Economics

 — Mark Frears

Talk, Talk, Talk

How good are you at communicating? Do you prefer face-to-face, texting, social media or email? In person does not seem to be as prevalent, given all the other options now available. Are we losing something here? Are emojis our new nonverbal communication? Did you know nonverbal is over 50% of what is received by listeners? Just because I roll my eyes does not mean what you are saying is not important! The markets had plenty to listen to this week.

Brain(ard)

On April 5, the normally dovish Federal Reserve Governor Lael Brainard spoke at a conference in Minnesota. Her speech was titled “Variations in the Inflation Experiences of Households,” but it gave us so much more. While she laid out the thesis of lower income families being more impacted by inflation, the headlines that came from this speech dealt with how the FOMC will deal with current high inflation.

When she got to the Implications for Outlook and Policy section, she drew the real attention. Saying that the bank needs to act quickly and aggressively to drive down inflation, she indicated that both a speedy reduction in the balance sheet, and rate increases are necessary. This implies aggressive 50 basis point moves, above the normal 25 basis point cadence. Balance sheet reduction is unwinding the quantitative easing that has been in place since the start of the Covid outbreak. They would stop buying U.S. Treasuries and mortgage-backed securities from the market, and at some point in the future start to sell their holdings. When they stop buying bonds, this will stop the flow of stimulative funds into the market. While rate increases in the overnight Fed Funds (FF) rate send an important message to the market, they do have an impact on longer term rates, other than through expectations. When they stop buying bonds in the open market, this starts to dry up liquidity, and this will have an impact, depending on the pace of their actions.

Federal Open Market Committee (FOMC) Minutes

In keeping with the focus on monetary policy, the minutes from the March 15-16 FOMC meeting were released this week. The reason for the scrutiny on these minutes is for insights into the actions that will be taken at the next FOMC meeting May 3-4. Bottom line, the outlook is for an aggressive, inflation-fighting plan of action. 

On the rate move front, they are fully ready to increase FF by 50 basis points at the May meeting and will do additional larger-than-normal moves if necessary. The point here is to send the message that they are serious about inflation. They would like to get to a neutral rate, balancing their two goals of full employment and price control. That would be approximately 2.25-2.50%, given their current view. The FF rate is now at 0.25-0.50%.

The projected size of the balance sheet reduction was also larger than expected. Fed officials deemed it appropriate that the runoff would ramp up to $95 billion per month over three months, beginning in May. This is much faster than the 2017-19 runoff that only reached $50 billion after a year’s ramp. They realize they need to be aggressive now.

Longer term inflation concerns from some committee members were cited, such as strong aggregate demand, significant increases in energy and commodity prices, and supply chain disruptions. While they acknowledge this concern, they also must keep in mind their not-so-great track record of tightening monetary policy too quickly, or too far, and leading the economy into recession. A delicate balance. 

ISM and Jobless Claims

In addition to the very important communication from the FOMC and its members, we also had some other noteworthy news. The Institute of Supply Management (ISM) manufacturing report for March showed some very positive trends. First, employment was up to 56.3 from 52.9, a 6% increase. Second, backlog of orders has been above 60 for the last few months, showing there is demand for product, and the firms have room to grow. Third, customer inventory has been below 40 for quite some time, showing the buyer has room to buy more product. 

Jobless claims continue to decline, staying close to historical lows. This shows the labor market is very tight, with fewer people relying on government assistance. Employers are doing everything they can to retain workers; wage and benefit increases could eat into corporate profits.