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

As of market close September 2, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Summer's over

Although the 1st marks the traditional end of summer, for the Bulls summer ended on August 18. Since mid-August, U.S. stock indices have given up roughly half of the summer rally’s gains. Bonds had it worst, with high quality names giving up all of their price gains. What ruined the rally? There is always more than one bad actor in Bear cycles, but we’ll start with the Fed. 

Over the last year, markets did not take the Fed seriously. For sure the Fed was too late in starting to raise interest rates. The Fed has staunchly sought 2% inflation over the last two decades. So, you can imagine we were quite perplexed when consumer price inflation hit 7.9% in February of this year before the Fed even began to raise rates. That was too late even for Fed standards. Recall that in February a year earlier CPI was 1.7%.  Hey that’s close enough for 2% and horseshoes, Fed. Call it victory and go back to managing the money supply. April 2021’s reading of 4.2% should have spurred the FOMC to action but it did nothing. 

Wall fight

Wall Street consistently projects inflation rolling over and heading toward 2% in the next couple of years. Essentially economists are trying to validate the Fed’s long-sought goal: return inflation to a “magical” 2% level. Current futures pricing for Fed Funds projects the Fed will stop raising rates next spring. The opinion expressed by pit traders is that the peak rate will average around 3.85%. Well, that is close to 4%, but still below. What are FOMC members saying? Above 4% short rates and keep them above that level for “some time.” What does Wall Street know that the Fed does not?

The Fed believes the only way to curb inflation is to kill demand. Aggregate demand comes from consumer spending and industrial new orders. Forcing interest rates high enough and withdrawing liquidity to the point where businesses stop expanding and start laying off workers is the tactic. Raising unemployment from 3.7% to at least 4.5% is their objective. Putting people out of work will, in theory, curb consumer spending. New orders and production surveys show that manufacturing is already meaningfully slowing. 

Looking ahead, fuel and fertilizer appear to be in tight supply. These inputs will pressure global food prices higher over the next couple of years. Computer chips are said to have rolling supply shortages as plants re-tool for new models and assemblers restart and shut. Wall Street may cheer lower inflation in the coming months. Remember CPI figures are the rate of change of prices. When CPI “drops” it just means prices are not rising as quickly as they were earlier. Prices are still going up. And no, we are not going back to 2019 prices on anything, anytime soon. A good portion of commodity and hard goods inflation comes from supply problems. Consumer inflation in this cycle has been driven by fiscal policy: spending by the government. The Fed is trying to curb both by focusing on employment. As with the shutdowns, we are in a global economic experiment. In uncharted waters, stick with the great Marty Zweig and Ned Davis: “Don’t Fight the Fed.”

Lower all over 

The headline payrolls number would make one think the economy is fine. Indeed, it’s not in bad shape at all. Fast money trades on how fast the change is changing (the second derivative if you care). In 2021 we were all about 2022 sliding gently lower toward trend growth. The economy’s rate of change would slow but still result in positive growth.

The ride has been bumpier and to lower levels than our base case. We may look back on 2022 and 2023 as a time of rolling recessions, where the big picture numbers, like payrolls and job openings, are fine, but pockets of the economy take their turn in no or negative growth mode. 

One thing the Street should know is that the economic data is worse than at the lows of June 16. Factory orders, production and retail spending are at best flat over the last three months. Adjusting for inflation, retail sales year-over-year are down 4%. Wages are growing, but slower than inflation. If production and spending are not keeping up, then company profit margins will not. Walmart was the canary in the earnings coal mine. We think. We may be early, but we believe third quarter earnings are going to feature managements lowering earnings expectations for this year and next. 

Cloudy outlook

On the 21st of September there was never a cloudy day (Earth, Wind, & Fire reference). On the 21st of this month the Fed should raise rates again. What would part investors’ clouds? One ray of sunshine would be an admission that, yes, we the Fed are behind, but we will not “rush and squash” the economy just to choke off demand. Another admission would be that the Fed will continue its increases but in a steady, every-meeting tempo. 

September is historically a bumpy month for investors. Since World War II it holds the bottom spot in terms of return performance for stocks. September tends to be a trend reinforcer. Our trusty Stock Trader’s Almanac tells us that if stocks are in a downtrend coming into the month, returns average -2%. If they are in an uptrend, the S&P 500 posts an average loss of 0.5%. 

There is always the question, “if it’s going down, then why not get out?” That is a trading tactic that, for pros, has a less than satisfactory track record. For intermediate and longer time horizons it can do lasting damage. We have watched this “going down, get out” tactic, and time and again, gains are forever lost after the exit. This cycle appears to be a non-recession Bear, a pause in a long-term Secular Bull.  If a recession follows, the Bear may stick around a few months longer. The one Bull marker we have on our board is the mid-term election cycle. Averaging all mid-term years back to the 1920s shows a rally starting around Halloween. We would welcome a treat or two.