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

As of market close April 22, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

• Fed speakers jawbone markets lower
• Bond market swing looks too far to us; expect rates to moderate in coming weeks
• Leading Indicators suggest no recession in sight
• Jobless claims continue to hit all-time lows

Open Mouth

Earlier this month, Randall Forsyth, the Associate Editor of Barron’s, observed that the FOMC now stands for “Federal Open Mouth Committee.” Never in our memory have we seen a more “transparent” Fed. Committee members have been out in force this month, jawing about bigger rate increases. Chairman Powell’s speech last week about a half-percent increase “on the table” at the May meeting moved stocks back into correction territory. 

Committee members Bullard and Daly also suggested three-quarters of a point increases could be considered. Wall Street dutifully ratcheted its rate increase forecasts higher. Nomura led the parade, calling for half of a point in May, and then two three-quarter point raises in June and July. That would push overnight rates to at least 2.25% by the end of July. 

We thought at the beginning of the year that the global economy would slow down quicker than the Fed believed and that they would not raise rates as high as they projected. Our belief started with the fundamental backdrop of coordinated efforts by central banks to pull liquidity from markets (quantitative tightening) and raising interest rates. We did not factor in prolonged war or China causing a third supply chain wave with their zero COVID policy. Combined with countries hoarding cooking oil and grains, the rest of the world could slow to recession instead of a mild cooling.

It appears Powell and Company are trying to follow the 1994 playbook: hit markets hard early in the tightening cycle with bigger rate increases to move rates higher and cool down the economy. Markets believe there is a very high probability of half point increases at the May and June meetings. We understand the Fed is worried that its inflation fighting cred is on the line. If the Fed is truly “data driven,” it should pause in the summer and look hard at the incoming economic statistics. A recessionary Europe demanding liquidity from the Fed and below trend growth thanks to China shutdowns should factor in how far the Fed pushes rates in the fall. 

Deflation

The Fed certainly is winning the inflation war in the public markets. Long-maturity bonds are deflating faster than most stocks. The 20-year maturity Treasury bond is down at least 17%, worse than the NASDAQ. Speaking of that tech-heavy index, Elon Musk’s bid for Twitter has not helped the social media group. After peaking in early February, the group is down over 52% this year. 

Some wonder when we will return to “normal.” Few areas of the economy will return to pre-pandemic conditions as global trade turns regional, the population continues to age and developed countries push “decarbonization.” However, interest rates are doing their part to get back to pre-pandemic levels. The two-year Treasury is a good example:

Note in the chart above that bond investors enjoyed the price gains on the way down from 2.97% to 0.14% during the pandemic. The rising rate pain has been more concentrated in the last couple of months versus the nearly two-year rally into the pandemic. The “U” shape of the two-year yield is not a typical chart pattern (understatement). We would point out that the left leg of the “U” was driven by the 20% increase in the money supply from Congress and the right leg is the resulting 10% inflation. 

Stocks have made their own U-turn, with the last three weeks erasing an 11% rally for the S&P 500. That index, along with most of the other U.S. indices, sits 24% above its pre-pandemic high. Developed international stocks sit just 5% above their pre-pandemic high and Emerging Markets are 6% below.

We think most of the deflation pain for bonds is past. Stock prices will likely continue to struggle until the Fed’s rate path becomes clear later in the summer. That coincides neatly with the mid-term election pattern of stock volatility calming down in the fall.

What About?

The Fed jawboning rates higher and stocks lower took the focus away from earnings. One-fifth of the S&P 500 has reported to date. Fortunately, 79% have reported positive surprises over analysts’ estimates and 69% positive revenue surprises. When major trends are changing, one must pay extra attention to management’s statements. By far the majority are guiding analysts’ estimates “in-line,” meaning they are staying the course for the year’s outlook. Maintaining positive outlooks in the face of labor and commodity inflation means they are comfortable with margin pressures and future orders. The year-over-year beat rate of 6.6% (FactSet) is the lowest in the last two years, but not surprising given the sharp increases last year. 

Bespoke Research points out that Apple, Alphabet, Amazon and Microsoft all report this week. That has happened less than 20% of the time in the last ten years. Unfortunately, when the MAGA group reports together, price reactions are usually weak. Over the next two weeks, 275 S&P 500 names report so we will have a good handle on earnings trends by the May 4 Fed meeting.  This is stalwarts’ week, which is a nice way of saying old-timers. GE, Sherwin-Williams (remodeling activity?), Westinghouse, Boeing, McDonalds and ExxonMobil.