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

As of market close April 29, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Rate Ruin

Powell Pain continued last week for stocks as traders accepted the possibility of 0.5% and 0.75% rate increases in the coming months. Fed Chairman Powell gave life to Wall Street’s darker rate fears on the 21st when he opined that half-point rate increases “were on the table” for this Wednesday’s Fed meeting. This morning, Fed Funds futures suggest a near 100% chance of a 50-basis point (half of a percent) increase in short-term rates. Year-end futures are projecting nearly 2.72%, which suggests at least four 50bp increases over the remaining six meetings this year. 

Inflation, however one measures it, is way beyond what the Fed expected. The Consumer Price Index has averaged 7.3% over the last six months. After a 0.5% increase this week, Fed Funds would average at least 0.75% this month. Three-quarters minus 7.3% equals a real interest rate of -6.55%. Rates are deeply negative, meaning that monetary conditions are incredibly loose. Historically, stocks do well when real rates are low to negative, and bonds fare well when real rates are positive, generally above 2%. 

The journey from -8% real rates back to zero has just begun. Bond traders are trying their best to “help” the Fed get real rates back to neutral. The two-year Treasury yield has increased by a factor of ten over the last six months to a 2.68% yield and the 10-year Treasury yield has nearly doubled to 2.88%. These fast swings higher have dropped bond prices between 3% and 20%. The speed of interest rate rises over the last two months has impressed many observers and caused pain on statements. We would point out that higher rates almost immediately add income to the portfolio and result in higher long-term earnings. 

Lower or Higher

If the CPI drops in half by the end of 2022, supply chains continue to heal and earnings margins can stay at record levels, then a Bull case can be made for the S&P 500’s current forward price earnings multiple of 18.2x. A year-end short rate of 2.75% with inflation of 4% still leaves real rates negative and favorable for stocks. Note that the two-year Treasury level today is below the year-end Fed Funds futures level. The two-year is a pretty reliable gauge of where short rates will be in a year. A lower two-year is telling us that markets think the economy may slow more than the Fed anticipates. 

Risks to our forecast of lower inflation include elevated home prices, regulatory policies restricting oil and gas production, and overheating labor markets. Any or all can keep inflation numbers higher for longer and pressure the Fed to go too far in raising rates. 
 

Yes, it’s late.

Higher inflation, rising interest rates and a possibly overheating jobs market check the boxes for a late-stage business cycle. The government shutdown, stimulus and recovery compressed a typical 5–7-year business cycle into perhaps 2.5 years. We are not convinced the Fed is aware of where the economy is in the current cycle. Mark digs into the details of the first quarter’s GDP below. 

Another late cycle clue are business inventories and new orders. Inventories are building partly because supply chains are improving and partly because consumers are guarding their wallets against higher prices. New orders for manufacturing are continuing to increase, but at a slower pace. Markets are watching these classic late-cycle indicators and are trying to price future earnings. 

The S&P 500 has gained 45% over the last three years but is down 2% over the last 12 months. Stocks rolling over in performance are also a late-cycle indicator. Digging into sectors and style, growth generally leads during expansions and value takes over near earnings peaks. Earnings growth appears to have peaked in the fourth quarter. On cue, the Russell 1000 Value index is down 6.7% this year, while its growth counterpart is down -20%.

A late-cycle economy does not have to endure a Bear stock cycle, however. Lower bond and stock prices at the same point in a cycle are rare in the post-World War II era. Most investors are accustomed to the low inflation / deflation regimen where bond prices rise to cushion stock prices falling. The rare periods when both rise or fall usually occur when the Fed is changing policy as we have seen today. The folks at Bespoke Research found six cases since 1977 where bonds fell at least 3% and stocks 5% in the same month. In all cases bonds were higher three and six months later. The S&P 500 was higher in most cases three months later and higher in every case a year later. 

Still Good

Nearly half of the S&P 500 has reported through last Friday. Amazon missed on higher expenses and Twitter may have had its last earnings announcement. On balance, the first quarter continues to meet or exceed expectations. Earnings are on track to grow a healthy 9.4% and revenues 12.1% over 2021’s first quarter. Eight of 11 sectors are showing earnings gains, led by Energy’s 253%. Financials, dependent on big-bank merger and trading fees, trail at -18% growth. 

Every sector but Utilities reports gains in revenue. 81% of companies have beat estimates to date, above the average 73%. On balance, the mega-tech names last week met expectations and posted sales gains. That was not enough for some traders who wanted big earnings surprises. In late-cycle expansions, big earnings beats are rare. This week 153 S&P 500 companies report, including fertilizer maker Mosaic, eBay, Clorox and Pioneer Resources.