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

As of market close October 21, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Time-warp

Last week’s rally brought the big indices back up to month-ago levels. Over that span they endured a 7% swoon and some of the largest daily swings on record. The economy continues to slow back to trend levels, employment remains strong, and inflation is peaking. So why the volatility? Big swings in stock prices generally occur around earnings and other company-specific news. Lately, volatility has been more news driven. Traders are looking for any indication that may cause the Fed to slow down its rate increases. 

Pulling out of the aforementioned swoon hinged on several FOMC members speaking about the possibility of the Fed slowing or pausing its rate increases. Traders bought stocks on the news, pushing stock data screens well into the green. The Fed meets Tuesday and Wednesday of next week. From last Friday through Wednesday the 2nd, Fed members are in “blackout,” not speaking to the press. Those speeches may have been the last indication of members’ thinking prior to the blackout. The months of hawkish “we are fighting inflation” rhetoric to the sudden switch to dovish talk about pauses or smaller rate increases make us wonder. Why the sudden excitement by traders, especially when the Fed’s forecast (the “dot plot”) says they would scale down the size of increases next year? Since stocks time-warped back a month in values, how about the Fed time-warp back to fighting inflation? 

MARE

What fundamental changes would kill the current Bear cycle? For starters, economic data bottoming and turning higher. Coincident indicators like unemployment and industrial production remain strong. Leading indicators, however, point to elevated recession risk in the coming months. The index has fallen six of the last seven months. The six-month rate of change in the index is now -2.8%, which is the lowest level in a decade, outside of the pandemic shutdowns. The Conference Board noted in its press release that the downward trajectory in the Leading Economic Index implies “a recession is increasingly likely before year-end.” So, no help from the Conference Board.

How about inflation peaking? Housing prices and apartment rents generally take a year to work their way into the Consumer Price Index. As Mark explains this week, the Bureau of Labor Statistics samples rental rates every six months. The S&P Case-Shiller Home Price Index measures home prices in 20 metro areas monthly. It began rising a full year before CPI did, and in turn, the Fed waited a full year after CPI to begin raising rates. The Fed knows that interest rate increases can take a full year to work their way through the economy. Not so with mortgage rates. Rising mortgage rates have already pushed housing affordability to near-record lows. In turn, the Case-Shiller Home Price Index began falling this June. How long will it take the Fed to realize CPI will be rolling over in the coming months? Will the Most Anticipated Recession Ever occur before the Fed quits? We think the odds are yes it can, but we do not have a definitive estimate yet. 

Somewhat okay

We do have reasonable estimates on earnings. To date, the third quarter earnings season is producing average beat rates — around three-quarters of reporting companies are beating analysts’ estimates. Only 20% of the S&P 500 members have reported, but earnings growth is running +1.5% year-over-year, above the -3% expected. A total of 159 members report this week and 164 next week, so by election day we will have a good sense of where the quarter stands. This is old-timers and new dogs’ week. GM, GE, Ford and Boeing along with Google, Apple and Meta will report. 

Inflation and the surging value of the dollar have compressed margins in most reports. The dollar in particular hurts overseas sales. The dollar rose 25% since the summer of 2021 versus the G-20 basket of currencies. A number of countries have sold U.S. Treasuries to raise dollars in order to buy up their own currencies. 

The Bank of Japan intervened in currency markets last Friday in a similar move to support the yen. We are not sure how much yen the Bank of Japan is willing to print but infinity is not the right answer. From 1985 to the end of last year, Japanese inflation has averaged 0.5%. This year it is averaging 1.9% and just hit 3%. We saw this movie back in the spring of 2021 when U.S. inflation jumped from 1.4% to 4%, on its way to 9.1% this June. One hopes the Bank of Japan saw our experience and took heed. A currency war or competitive devaluations would be the last thing companies and consumers need right now.