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

As of market close July 15, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Brief reprieve

Friday’s option expiration rally gave the news media plenty to speculate over. Friday’s 2% rally in the big stock indices was a nice way to minimize an otherwise down week. We mentioned last week that when analysts drop estimates more than 15% right before the season, stocks usually react well. There is always a multitude of reasons why markets move any direction. Last week two stood out: the consistent drumbeat of a Fed-induced recession and decent earnings.

To be sure, traders were encouraged by improvements in retail sales, industrial production and the New York Fed’s manufacturing survey. All were better than expected after six weeks of slowing data. Friday’s advancing volume and ratio of advancing stocks over decliners were well into Bull territory. The S&P 500 notched only one new high on Friday however, set against 31 new 52-week lows. We are encouraged that the June 16 low has not been tested over the last 18 trading days. The five trading days prior to Friday all had lower closes but their intraday patterns saw an ugly start followed by Bulls winning most of the day, making each day a much smaller loss. These are some technical signs that stocks may be trying to bottom. Overall, there is still not enough evidence to call a turn for the better.

We continue to keep our stock allocations overweight toward the US. At times this year emerging and developed international markets have posted better performance than US stock indices. This month the tables have turned back in favor of the US. Fuel shortages and inflation have pulled European data into recession levels.

China, trying to work its way out of a historic real estate bubble and repeated virus shutdowns, has had one of its worst weeks in several years. The Hang Seng index, which is about 30% of the MSCI Emerging Markets index, has dropped 10% in the last 13 trading days. The early read on China’s second quarter GDP suggests nearly a 10% annualized decline. Their stock charts do not suggest a turnaround any time soon.

Drumbeat

The June CPI print of 9.1% and PPI of 11.3% were amazingly strong. “Normal” supply chain inflation would have abated by now. The details show inflationary pressures are spreading across all components instead of staying confined to food and gasoline. Rates futures markets promptly increased odds of a 1% rate increase by the Fed at the July 27 meeting. By week’s end much of that fear had dissipated and Fed speakers were on the tape talking up 0.75%. 

The Fed remains committed to using its two primary tools to kill inflation: raising interest rates and reducing the amount of money flowing in the banking system. The problem is that neither of these tools directly affect price changes. Yanking balances directly out of accounts would reverse the direct stimulus from March 2021 by cutting the supply of money. Since the Fed cannot do that, it must try to kill demand by raising rates. Rather brutal logic. 

The prospect of rising rates again pushed two-year Treasuries above 10-year maturities last week. The two-year yield of 3.12% is 20 basis points above the ten’s 2.92%. That level is consistent with a greater than 80% chance of a recession over the next year. The drumbeat for recession grows louder on Wall Street.  

What if the rate changes and liquidity withdrawals by central banks are already slowing the economy? Certainly the housing and mortgage creation statistics show a slowdown is in progress. Can we slow just enough to a “soft landing” without going into a recession? Data over the last two weeks suggests the Fed may go too far over the coming months and have to pause its rate increases in the fall. As recession odds increase, our indicators will begin moving more toward long-maturity, high-quality bonds.

Earnings

One area that has slowed dramatically over the last month is input prices. Grains, base metals and other manufacturing inputs have fallen 15% to 20% in price. Traders are starting to question how long demand will stay strong in the face of rising prices. The best information source about demand is company orders and their outlooks. The Street will be paying closer attention to outlook reports from management than their second quarter results. 

The big banks mostly missed estimates last week. Citibank’s stock responded the best, rising 11% on solid revenue growth in its credit card business. Like the rest of the big banks, loan growth was below projections and securities trading helped the bottom line. Conagra, one of the big four food producers, missed estimates and lowered guidance. In what may become a common refrain over the next three weeks, management guided 2022 estimates lower from 8% earnings growth to 3%. Ouch. 

Another pain for earnings is the strength of the US dollar. In 2021, investors wanted dollars so they could ride the US recovery. Now rising interest rates and slowing growth outside the US mean folks are scrambling to sell assets to raise dollars. That increasing demand has pushed the dollar 13% higher this year against its basket of six currencies. Of that 13%, half of that rise came since the end of May. Expect dollar strength to be a topic on earnings calls in the coming days. Companies like Intel and Nvidia that have most of their sales overseas will have a tougher time meeting their estimates. 

The Euro makes up 57% of the basket and has fallen to near parity with the dollar. If you can get flights, now is the time to see Europe. The last time the two currencies were equal was 2002.  

This week 72 S&P 500 companies report. Bank of America and Goldman Sachs finish up the money center banks today. Lockheed Martin, Baker Hughes, Tesla and Twitter will make for an interesting news cycle this week.