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

As of market close April 14, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

• Stocks slogging into earnings season
• Fed moved extremely fast to cut rates; moving slow to raise? 
• Global headwinds of China COVID-19, war, drought, supply chains crimping Euro growth
• Peaking: 8.5% Consumer Price inflation driven by fuel (+48%) and used car prices (+24.8%)

Frustration

Happy Income Tax Day. The holiday-shortened week should have put smiles on traders’ faces. Instead, most are still scratching their heads, trying to figure out Mr. Market’s direction. The short answer is that markets usually sort themselves out before the economy turns, regardless of the direction. We thought back in March that the lows for the correction were in. We are sticking with that thought for now. The ups and downs for stocks since the March lows have been contained in the typical 38% to 62% bands of the Fibonacci retracement levels. In other words, a typical directionless consolidation. 

There are lots of behavioral biases out there and we are not qualified to understand or comment on them. There is a name for what is going on versus what traders “see.” Here is what we see: stocks consolidating while waiting on the Fed and decent earnings reports. Net new highs by individual stocks are well above levels associated with falling markets. 

Higher interest rates and food prices are coming — they are unavoidable. Markets have had months to discount these factors into prices. The war’s length and destruction are unknowns, but the outcome of a divided Ukraine has the highest probability. Inflation, as Mark points out below, is likely peaking and will stay “higher for longer” thanks to Chinese lockdowns affecting supply chains.

So, what are traders seeing? Investor sentiment is at a nearly two-decade low. Institutional trader sentiment is barely neutral but trending negative. The attitude seems to be more, “What bad thing is next?” instead of, “When will this be over?” We tend to look at markets using the later lens. History suggests that the summers of midterm election years are the bumpiest with a first-term president. On the other side of the summer, however, Bespoke Research points out that when sentiment is this low, stocks are higher six and 12 months later almost every time. 

Leisurely Pace

We and many others saluted the Fed at the beginning of the pandemic when they cut rates quickly and supported markets. On the other side of recovery, we find the Fed returning to pre-pandemic levels of liquidity and rates in slow-walk mode. Inflation’s inflection point was March a year ago. Yet the Fed waited 12 months to enact a no-effect quarter of a point increase. It should release details of its bond portfolio reduction program on May 4. That program is also turning out to be a fast up / slow down affair. Recall the Fed quickly added nearly $2 trillion in bonds to its balance sheet and after four years had added approximately $4.3 trillion. Now it will take several years to unwind these positions at the leisurely pace of $1.1 trillion per year — subject to “incoming data” and being “flexible.” In other words, if there is additional slowdown from inflation like we saw in the first quarter, easy monetary conditions could persist for much longer. 
 

Too Fast

Our musty textbooks tell us that higher interest rates reflect a bustling economy demanding more credit. Bankers would then raise the price of credit, charging a higher interest rate. But the higher-rate evil twin to more credit demand is the specter of higher inflation. Inflation, the buzzword for a growing supply of money, raises the price of everything. 

Fed speakers have been out in force over the last month, spreading an inflation-fighting message of rate increases. This “jawboning” put traders on notice and they started selling. And selling. The Bloomberg U.S. Aggregate Bond Index fell 5.9% in the first quarter, its third worst quarter since the index was created in 1975. April’s 3% drop adds to the pain. Bank of America analysts stated last week that approximately 0.67% of the 10-year Treasury’s 1% move in the last few weeks was due to Fed speeches. 

The 10-year Note, along with the rest of the yield curve, has been on a tear since its recent low of 1.17% last August. This morning it touched 2.86%, its highest level in three and a half years. While most bond managers expected interest rates to return to their pre-pandemic levels, few believed it would happen this fast. What fueled the rapid rise? Remember the Fed is racing to catch inflation, not the other way around. The three rounds of direct payments to consumers from Congress during the pandemic get most of the blame. The charts suggest that most Treasury maturities are oversold and overextended. A pull back or pause is in order. Believe it or not, bonds are becoming relatively more attractive versus the last three years. Times do change, sometimes too fast. 

As Expected

Earnings season got underway last week in an underwhelming way. As a group, the big banks beat estimates on trading and broke even on investment banking fees. Profits were lower than a year ago at every bank. Wall Street expects lower profit growth this year than last for most of the S&P 500. FactSet estimates that profit margins have decreased about 0.5% from last year’s record-setting 13.1%. They pin the drop squarely on inflation, both in materials and labor costs. If companies can maintain 12% gross margins, the S&P 500’s earnings per share should hit forecasts of 9% growth. 

The last two years of pandemic recovery drove banks’ mortgage, M&A deals and trading profits. Last week’s reports of lower earnings in all those areas show the return to slower growth is at hand. War, inflation and supply chain uncertainty may put some deals on hold. At the same time, Wells and others pointed out that business loan growth is improving, thanks to borrowing to cover increased costs. Citigroup’s CEO Jane Fraser summed up 2022 well: “The macro-outlook for the rest of the year can only be described as complex and uncertain.”

We agree with her sentiment. Over the next several weeks, earnings release conference calls should give traders an idea of uncertainty around supply chain issues. Shanghai and Guangzhou ports remain nominally open, but several assembly plants for makers such as Apple, Dell and Lenovo remain shut or at limited capacity. Europe and the U.S. experience with omicron suggest China will be in some form of lockdown for another month or so. 

Several things we are certain about, however, are corporate and consumer balance sheets being in great shape, a strong labor market, and slowing inflation reports in the coming months. This week 68 S&P 500 members report. Over half of the index members report the last week of April and first week of May. Like margins, analysts are keeping earnings estimates at record highs. Heavyweights this week include J.B. Hunt Transport, Lockheed, Union Pacific, Tesla and Netflix.