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

As of market close October 28, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Another week

Another Fed narrative. Here goes: “After the European Central Bank, Bank of Canada and weaker GDP numbers, surely the Fed will slow down its rate increases.” A lot of last week’s action was based on this (hope) narrative, along with short covering in European bonds, the euro and British pound. Both central banks raised their interest rates but lowered their economic forecasts. The Bank of Canada surprised traders by only raising rates one-half of a percent instead of the expected three-quarters. 

The Fed meets again this Tuesday and Wednesday. Traders expect the Fed will announce a three-quarters of a percent increase in overnight rates. Bets are evenly split between a half and three-quarters of a percent at the December 14 meeting. The excitement for markets has moved to the February 1st meeting. The latest “Bullish” Fed narrative has the Fed stopping its rate increases at the December meeting or just making small quarter-point increases starting in February. 

In front of the Most Anticipated Recession Ever, the latter scenario would be the best of outcomes. Small rate increases would show the Fed is still “on the job” to fight inflation but would let the members see the impact of three straight 75 basis point increases. Housing has already entered a recession. Shortages of diesel fuel and fuel additives may start to crimp deliveries and transportation, keeping inflation elevated. FedEx warned about slowing delivery activity back in September. Amazon took the stage last week with a dim holiday outlook. 

People close to the Fed tell us members of the Open Market Committee are determined to bring down inflation. They are embarrassed that they are so far behind in this inflation cycle. Every rate increase cycle has ended only when nominal overnight interest rates are greater than inflation. The Fed’s favorite inflation gauge, Personal Consumption Expenditures, is running at a 6.2% pace. Overnight Fed Funds range from 3% to 3.25%. The Fed is halfway home. We think they meet around 5% in late spring. Then the Fed may think about a pause. 

Below one

Last Thursday’s release of third quarter real GDP registered +2.6%. No recession, correct? Well by some measures, yes, no recession. The first two quarters of the year were funny GDP accounting and showed negative real (inflation-adjusted) growth. To get that +2.6% annualized growth, the BEA had to use an inflation rate of 4.1%. Remember that the consumer price index is running at 8.2%. 

At the risk of raining on the Rally Parade, in the third quarter net exports grew 2.7%, or greater than the headline number. A big chunk of that export growth was oil shipments from our Strategic Reserve and shipments of weapons to Ukraine. Not exactly economy-building activity. In nominal dollar terms, the U.S. economy has grown less than 1% in 2022. The economy continues to grow but has downshifted to first gear. A first gear economy means flat earnings, fewer job openings and lower wage growth in coming quarters. 

Treats 

Today may have a few tricks, but October’s stock performance is all treats. Last week’s moves are not only greater than a “good” full month of October, but they also approach the average gain for the full fourth quarter. For the month, the Dow Jones Industrials surged over 14%; the S&P 500, 8%; and the tech-heavy NASDAQ, a measly 3.75%. Tech has pulled the performance cart for at least the last five years, but higher interest rates are taking their toll on valuations. On the hardware side, the recent export ban to China of some sensitive chips will hurt earnings. In social media, Meta (“Facebook” for the grandparents) lost a quarter of its value last week after reporting slower ad growth. 

Bear in mind that Bear cycles always have the sharpest rallies. On average a 10% up move in a Bear cycle lasts around 59 days versus Bulls around 100 days. A Bloomberg analyst pointed out that the S&P 500 has rallied over 1% three days in a row just 75 times since 1928. Streaks of four days are even more rare and tend to come in recessions. The Dow’s double digit move in 13 trading days certainly makes us scratch our heads. Interest rates have had a similar sharp rally, with the 10-year Treasury falling from an intraday high of 4.33% on the 21st, to 4.04% this morning. The two-year Treasury also round tripped from 4.63% the same day to 4.48% this morning. 

We like rallies as much as anyone but are mindful that the fundamental picture continues to deteriorate. Most of the earnings calls we reviewed paint a flat to dour picture for the next two quarters. Companies are clearly pulling in their horns and minding their cash balances. If we are at the edge of a rolling recession, where various parts of the economy slow down but overall growth plods along, then a bottoming process and fall rally for stocks make sense. If as fundamental indicators like the Leading Economic Index and Purchasing Managers Surveys suggest, the MARE is coming in the spring, then October is the start of just another countertrend rally that will turn lower in the coming months. 

Stop cutting

Back at the beginning of the third quarter earnings season, more firms were raising guidance than cutting. FactSet now reports that more firms are cutting guidance. Revenue and earnings growth are running barely 2% over the year-ago third quarter. Most of the positive results come from the energy sector’s 134% increase in earnings from last year. Without energy, the rest of the S&P 500 is on track for a 5% decline in earnings. We would like companies to stop lowering guidance and analysts their estimates. Considering the first gear  economy, we may have to wait a couple more quarters. This is the biggest week for S&P 500 reporting with 163 companies presenting results. Ecolab, Pfizer, Lilly and Phillips 66 are some of the names we are waiting on.