Weekly Market Report: August 5, 2022

Markets last week continued to digest a heavy slate of corporate earnings and a modest economic calendar punctuated with the July jobs report on Friday. What had been another good week was met with some policy anxiety in response to Friday’s extremely strong jobs report which implied the Fed has more work to do to tame inflation and a hot job market. U.S. equity markets managed to finish up for the week with technology and small caps setting the pace while developed international markets lagged. Interest rates moved sharply higher, in response to increased likelihood of a more hawkish FOMC, with shorter 1yr-5yr rates all increasing nearly 30bps. Commodities fell 6% on the back of a sharp decline in oil prices (-9.74%) to close below $90.

Market Anecdotes

• The move higher in interest rates last week poses a threat to one of the biggest drivers of positive equity market returns we experienced in July. Falling interest rates last month also contributed greatly to the recent decline in the USD. 
• Interesting anecdote on the impact of P/E multiple compression on the Russell indices is that the R1000 Value now includes prior growthy names such as Netflix and Facebook while the R1000 Growth included Coca Cola and Procter & Gamble. 
• Market reaction to the overwhelmingly robust July jobs report can be categorized as ‘good news is bad news’ with futures pricing in a more aggressive tightening path and a higher terminal rate. 
• Inflation data for July and August will ultimately determine the Fed’s path and decision in September but the robust labor market certainly gives them some cushion. 
• Global inflation has yet to abate but falling commodity prices (including oil) are providing some hope. Oil’s notable break to the downside is clear but Russia/Ukraine, China zero Covid, and global growth combined translate to extreme levels of uncertainty. 
• Gas prices have fallen for over 50 consecutive days and $1.00 from the peak, now around $4.11 per gallon with some areas of the country actually seeing a two handle on a gallon 
• How much growth will have to recede to achieve lower inflation is the million-dollar question to which nobody has the answer. Albeit a notably different inflation backdrop, a look at the early 1980’s does little to inspire confidence. 
• Over 800 companies have reported 2Q earnings thus far with decent beat rates and underwhelming beat magnitudes. Upward guidance has fallen from 20% to 10% over the past few quarters but 10% is still an impressive number. S&P 500 earnings and revenue growth sit at 6.7% and 13.6%. 
• The BCA bull contingency noted the strong possibility of 2Q GDP being revised to positive growth in addition to noting Q1 real GDI increased 1.8% in the first quarter. 
• Renmac noted Italy’s fundamental fiscal unsustainability for which the ECB TIP can only buy time. Substantial fiscal reform and/or debt restructuring seem increasingly likely at some point.

Economic Release Highlights

• July’s Employment Situation reported new jobs of 528,000 far exceeding consensus of 250,000, taking the unemployment rate down one tick to 3.5%. 
• Labor market participation fell one tick to 62.1% and average hourly earnings came in higher than consensus with growth rates MoM (0.5% vs 0.3%) and YoY (5.2% vs 5.0%). 
• The June JOLT Survey revealed 10.698mm job openings, fewer than the 11.0mm forecasted and well below the 11.303mm openings in May. 
• The July ISM Manufacturing Index registered 52.8, slightly higher than the consensus forecast of 52.2. 
• The July ISM Services Index came in at a robust 56.7, well above consensus of 53.0 and higher than the high end of the forecasted range.

Weekly Market Report: July 29, 2022

Markets last week digested a highly anticipated FOMC meeting, a very busy economic calendar, and the busiest week of earnings reports for the Q2 reporting season. The net effect was a strong rally in risk assets with U.S. equity markets rising over 4% as well as non-U.S. developed (+3.7%) and emerging (+1.4%). Bond yields fell, mostly in the belly of the curve, leaving the 10yr UST yield at 2.67%. Commodities rallied over 4% with broad based gains across energy, grains, and metals while the USD weakened in sympathy with the risk-on tone of the markets.

Market Anecdotes

• Last week’s FOMC meeting delivered the expected 75bps rate hike, bringing rates from zero to the Fed median projection of “neutral” (2.25%-2.5%) in four months (ala Volker). The Fed also abandoned forward guidance and highlighted attempts to balance growth and inflation risks.
• Market reactions consisted of a risk asset rally, falling yields, and a tempering of future FOMC rate hikes. Markets see the terminal Fed Funds rate at 3.31% in January 2023, down notably from 4.06% in mid-June, and rate cuts beginning thereafter. The Fed has never stopped hiking before Fed Funds exceeded CPI.
• The tug of war between Wall Street (growth focus) and the Fed (inflation focus) will be the key determinant for risk assets and the economy looking forward.
• Inflation data is likely just beginning to moderate, but inflation expectations have moderated as TIPS break-evens, 5yr/5yr forwards, inflation swaps curve, and consumer survey data suggest.
• Over 35% of the S&P 500 reported earnings last week. Positive earnings surprises grew to net a blended Q2 growth rate of 6% with beat rates and margins of 73% and 3.1% respectively. Revenue is growing at 12.3% with beat rates and margins of 66% and 2.5%.
• Twisting yourself inside out to decide whether the U.S. is in recession? Q1 GDP of -1.6% followed by Q2 GDP of -0.9% viewed through a lens of the labor market, personal consumption, and the highly abnormal boom of pandemic recovery dynamics make the answer about as clear as mud.
• With the Fed owning over 30% of the treasury market and actively in QT mode, the slope of the U.S. Treasury yield curve has likely lost its efficacy as an indicator.
• Something in the energy markets of potential significant impact is the G7’s attempt to establish a global ‘buyers’ cartel’ to establish a price cap mechanism on Russian oil prior to the December 5th EU ban on insurance and services for vessels transporting Russian oil.
• A closer look at U.S. money supply might be one of the best explanatory variables for elevated U.S. inflation relative to the rest of the world.

Economic Release Highlights

• The June Personal Income & Outlays report revealed PCE inflation near consensus with headline readings of 1.0% vs 0.9% MoM and 6.8% vs 6.7% YoY and core readings of 0.6% vs 0.5% MoM and 4.8% vs 4.7% YoY.
• June Personal Income & Outlays showed personal income (0.6% vs 0.5%) and personal consumption expenditures (1.1% vs 0.9%) both increasing more than expected.
• Second quarter Employment Cost Index of QoQ 1.3% vs 1.1% and YoY 5.1% vs 4.6% registered higher than forecasts.
• U.S. 2Q GDP registered -0.9% for the second quarter, within the consensus estimate range of -1.1% to 1.5%.
• Euro area 2Q GDP accelerated from 0.5% q/q in Q1 to 0.7% q/q in Q2, significantly better than the 0.2% anticipated.
• The Conference Board’s Consumer Confidence Index for July came in near consensus at 95.7 versus 96.8.
• June New Home Sales of 590K were below consensus forecast of 664K and range of 620k-680k. Pending Home Sales (-8.6% vs -1.0%) missed notably to the downside.
• May Case-Shiller Home Price Index up 1.3% over the prior month, below both forecast of 1.6% and range of 1.5%-2.1%.
• June Durable Goods Orders surprised to the upside registering 1.9, well over consensus forecast of -0.5% and range of -2.5%-0.8%. Ex-Transportation (0.3% vs 0.2%) and Core Capital Goods (0.5% vs 0.2%) also beat to the upside.
  

Weekly Market Report: July 22, 2022

Last week we saw increasing economic concerns both domestically and abroad and a relatively downbeat earnings calendar met by a strong move higher in global risk markets, keeping in line with the market’s tendency to look beyond today’s headlines. While we don’t think we are out of the woods just yet, U.S. equities did cross through some key technical thresholds on their way to solid 2.55% gains, now sitting 7.8% above the June 17 lows, while developed international (+3.25%) and emerging international (+2.05%) both posted strong gains as well. Oil fell back below $95bbl while industrial metals posted gains netting a 0.75% gain for composite commodity markets. Interest rates continued to fall, particularly in the belly of the curve leaving the 10yr at 2.77%.

Market Anecdotes

• Last week the S&P 500 and Nasdaq both managed to break back above their 50-day moving averages which had been the longest sub-50-dma for the S&P 500 since the 2008 Financial Crisis. 
• 21% of the S&P 500 has reported 2Q earnings with blended bottom- and top-line growth of 4.8% and 10.9% respectively. Beat rates and beat margins are both below their 5-year averages with both unusually high 2Q 2021 comparisons and slowing macro environment contributing. 
• A bear market and looming potential recession has pressed S&P 500 valuations from a record highs of 27.2x down to 17x, much closer to its historical average. 
• Renmac noted that overdone negative investor sentiment, including the recent BoA/ML Fund Manager Survey, has been one of the more consistent rally indicators during the bear market which was on display again last week. 
• With the FOMC meeting this week, Bianco Research noted the Fed has never stopped hiking rates until the funds rate exceeded CPI and given the current respective levels of 1.75% and 8.60%, we have quite a gap to close. 
• The ECB began its first rate tightening cycle in eleven years last week with a 50bps hike while the BoJ maintained their ultra-loose -0.10% reference rate, reiterated its pledge to continue to be a buyer of 10yr JGBs at a yield of 0.25%, and reinforced its dovish forward guidance.
• While the 10yr UST yield has fallen from mid-June level of 3.49% to 2.77% last week, mortgage rates too peaked above 6% and have stabilized around 5.75%.
• Interestingly, high yield bond spreads have fallen from recent highs of 5.99% on July 5th back below 5% last week, implying a 12-month spread implied default rate of 6.65% – notably below normal recessionary default rates of 8%. 
• While the FAO food price index has decelerated for the past three months, it was up 23.1% in June – why we welcome a Russia/Ukraine deal signed last week lifting the Black Sea blockade of Ukrainian grain (and fertilizer) exports and allow Russia to resume grain exports as well.
• Thankfully, Europe’s Nord Stream 1 pipeline resumed flows of natural gas last week.
• In what will no doubt be a movie one day, it became public last week that an ex-Coinbase employee (Ishan Wahi) was caught frontrunning token issuance and arrested attempting to flee the country to India.

Economic Release Highlights

• U.S. flash PMIs for July fell from 52.3 to 47.5 with more weakness across the service sector than anticipated and manufacturing easing 0.4 to 52.3. 
• The June Conference Board LEI fell by 0.8% after a 0.4% decline in May. 
• Eurozone flash PMIs for July dropped from 52.0 last month to 49.4, now in contractionary territory with June Housing Starts (1.559M vs 1.588M) and Permits (1.685M vs 1.666M) both came in at consensus expectations. 
• June Existing Home Sales of 5.12M came in under consensus estimate of 5.395M and under the low-end consensus range of 5.15M to 5.5M. 
• The July Housing Market Index again fell short of consensus expectations, registering 55 versus consensus forecast of 66. 
• Eurozone CPI for June rose 0.81% MoM and 8.65% YoY.

Weekly Market Report: July 15, 2022

Last week brought us another up and down week with the official start of second quarter earnings and several highly anticipated economic reports as the key focus points. By the end of the week, we saw most global equity markets close down with U.S. (-1%), developed international (-1.5%), and emerging international (-3.6%). Inflation and growth concerns weighed heavily on risk appetite which translated to a strengthening USD, a rally in longer dated U.S. Treasuries, and a selloff in shorter dated U.S. Treasuries. Commodity markets were down again, losing 5.6% on the week, as oil closed back below $100bbl, gasoline prices fell but natural gas surged 16% to over $7.

Market Anecdotes

n eye watering July CPI report pushed market expectations for FOMC interest rate hike in July to 100bps immediately which slipped to 31% by week’s end. There was nowhere to hide across the subcomponents with gas, shelter, and food the driving forces.
• According to the New York Fed’s Survey of Consumer Expectations, the median 1 yr fwd inflation expectation surged to 6.78% while the median 3yr fwd fell to 3.62%.
• The strong USD should cut into inflation and GDP growth on a lagged basis, something the Fed is considering with respect to monetary policy. Softening commodity prices should also factor into near term inflation trajectory.
• Bespoke referenced a ‘bull whip effect’ as an interesting analogy to the aggregate demand and supply chain issues plaguing the economy since March 2020 in the form of an unprecedented pandemic demand shock and a series of overcompensations and over corrections by consumers, inventory intermediaries, logistics suppliers, producers, policy makers, and governments.
• The U.S. 2yr/10yr yield curve has fallen into its deepest inversion (-0.227%) since 2001 but the 3m/10yr (0.78%) remains slightly positive, at least until the FOMC hike later this month.
• Second quarter earnings started last week with reports from the banks. With 7% of the S&P 500 reported, we have a beat rate of 60% and a beat margin of 2%, taking blended earnings down to 4.2%. Revenue beats of 60% and beat margins of 0.8% are also coming in below average.
• The Bank of Canada hiked rates by 100bps and the RBNZ by 50bps to take both reference rates to 2.5%. The ECB meets this week and the FOMC on the 27th with markets pricing in rate hikes from both central banks as well.
• ZEW Survey of German investor sentiment fell to its lowest level since 2011 as inflation concerns abound. Natural gas concerns continue to rattle Europe with efforts to reduce reliance on Russian gas leading to increased likelihood that Russia will use the leverage while it still has it.
• Fresh political turmoil in Italy contributed to a rough week for European equities (-4.2%) with Mario Draghi tendering his resignation which was promptly refused by the head of state.
• A JPMorgan Chase report related the significant increase in interest rate (bond market) volatility to less market liquidity under the vastly expanded size and scope of the U.S. Treasury market noting BrokerTec data indicating only 25% of market depth relative to the past decade.
• Our strategists are discounting China’s record trade surplus posted in June as well as the 2.6t RMB infrastructure package recently announced.

Economic Release Highlights

• Retail Sales for June bounced back from May’s disappointing result with headline (1%a vs 0.9%e), ex-vehicles (1%a vs 0.6%e), and ex vehicles & gas (0.7%a vs -0.2%e).
• June CPI rose more than expected on the back of May’s upside surprise. Headline CPI jumped from 8.6% to 9.1% YoY and from 1.0% to 1.3% MoM. Core CPI moved from 6% to 5.9% YoY and 0.6% to 0.7% MoM.
• UofM Consumer Sentiment for July of 51.1 came in slightly higher than the forecast of 50.0 but was generally within consensus range of 48.4-53.0.
• NFIB Small Business Optimism Index tumbled to 89.5 in June, falling short of the 92.9 consensus estimate.
• June Industrial Production came in short of consensus (-0.2%a vs 0.1%e) with manufacturing output of -0.5% also missing consensus call for 0.2% growth.

Weekly Market Report: July 8, 2022

In a Fourth of July holiday shortened trading week markets digested a handful of economic reports and waited in anticipation of the upcoming 2Q earnings season to kick off. Risk appetite seems to have clearly shifted from valuation centric selling pressure to more concerns surrounding the outlook for growth and corporate earnings pressure. By the end of the week, the S&P 500 added 2% with the best performance coming from the most beat up sectors on the year (technology, consumer, communication) while energy, materials, and utilities lagged. Interest rates bounced last week, moving approximately 25bps higher across the curve, leaving 10yr yields back above 3%. Commodities (-3%) lost more ground with oil down 3.4%. The USD enjoyed another strong bid, up 1.8% on the week, taking year to date return to a whopping 11.8%

Market Anecdotes

• A not so surprising anecdote is that the S&P 500 marked its low point in mid-June corresponding to a highwater mark in interest rates and oil prices.
• Up until June 8th, the Energy sector was the only thing working in the market. However, the sector has reversed dramatically with oil closing below $100bbl and energy stocks falling close to 25%. That said, supply side dynamics should keep oil prices relatively firm.
• S&P 500 earnings are expected to rise 4.3% which should translate to approximately 9%-12% based on historical beats and leaves the S&P on track for 10% growth for the calendar year.
• June FOMC meeting minutes released last week revealed taming inflation and salvaging credibility as key considerations alongside testing the Fed’s resolve, long run inflation expectations breaking from the Fed’s 2% target, and inflation risks being skewed to the upside.
• Incoming data and the economic outlook will continue to inform the Fed including likely inflation pressure relief from falling commodity prices, declining shipping rates, easing supplier delivery backlogs, labor market dynamics, and shifts in consumption from goods to services.
• Supply chains are continuing to heal. ISM survey respondents reporting commodity categories in short supply have fallen from 36 to 13 in manufacturing and 33 to 14 in services while the GSCPI from the NY Fed also confirms easing pressures.
• Reports out of China suggesting that the Ministry of Finance is considering allowing local governments to bring forward 1.5 trillion yuan ($220 billion) of next year’s special bond issuance to the second half of this year catalyzed a rally in Chinese equities last week.

Economic Release Highlights

• The June Employment Report revealed 372,000 new jobs, comfortably beating the consensus estimate of 270,000. The unemployment rate stayed at 3.6%. Average hourly earnings MoM of 0.3% and YoY of 5.1% were generally in line with consensus. 
• June ISM Services Index (55.3a vs 54.8e) came in slightly higher than the consensus estimate. 
• June’s final U.S. PMI readings (C, M, S) of 52.3, 53.0, 52.7 saw a slowdown in manufacturing but more resilience across services with an upward revision to the flash report from the prior week. 
• The JOLT Survey reported 11.254 job openings. 
• China’s Caixin non-manufacturing PMI jumped to 54.5 in June from 41.4 in May.

Weekly Market Report: July 1, 2022

In a week that saw the S&P 500 wrap up its worst first half in over 50 years (1970), equity  markets delivered a fourth losing week out of the past five, remaining squarely in bear market territory as investors continue to look for guide posts in the second half. The week brought us some highly anticipated economic data on inflation, housing, and consumer confidence. U.S. equity markets were off approximately 2.3% while non-U.S. markets fell 1.7% with weakness again in technology/consumer and strength in utilities/energy. Bonds rallied sharply as interest rates fell again, leaving the 10yr now back below 2.9% while commodities lost 2% and the USD rallied 0.9% in a flight to safety bid.

Market Anecdotes

• With the second quarter and first half officially in the books, it warrants acknowledging the historic stock, bond, and commodity market returns thus far in 2022.

• The S&P 500 has repriced itself by -24% in P/E multiple terms heading into 2Q earnings season where consensus 2022 earnings sit at $229.23, a 10% increase over 2021 earnings.

   

• The notable change in Fed focus and tone in mid June when officials noted “economic activity appears to have picked up” has become more curious given the slowdown in both economic and inflation data. The paths of inflation and rate hikes remain pivotal input for risk assets.

   

• The outlook remains very unclear with the bullish view that $2.2t in savings will provide a significant boost to consumption offset by the bearish view that inflation is exacting a damaging impact on purchasing power and real consumption.

   

• The shift in consumption from goods (-$43b) to services (+$76b) continued in May which should be helpful for inflation pressures but it remains unclear whether the increase spend on services will offset declining demand for goods.

   

• Probability that the U.S. economy is in recession continues to increase with the most recent Atlanta Fed GDP Now model estimating a 2.1% contraction, following Q1’s 1.6% decline.

   

• A look at the yield curve shows both the 10yr-3m and 10yr-2yr slopes are still in positive territory but the 10yr-2yr is approaching the 0% threshold.

Economic Release Highlights

• PCE headline inflation for May came in MoM at 0.6%a vs 0.7%e and YoY at 6.3%a vs 6.5%e while core inflation registered MoM at 0.3%a vs 0.4%e and YoY at 4.7%a vs 4.8%e.

   

• Personal Income and Outlays report for May reported underwhelming consumption expenditures (0.2%a vs 0.5%e) and at consensus personal income (0.5%a vs 0.5%e).

   

• The June ISM Manufacturing Index came in slightly under consensus (53a vs 55e) but did fall within the broader consensus range of 52 to 56.

   

• Durable Goods Orders for May came in above consensus (0.7% vs 0.1%). Ex-Transportation (0.7% vs 0.4%) and Core Capital Goods (+0.5%) were also relatively strong.

   

• Pending Home Sales Index for May of 0.7% beat the consensus call of -2.5% and registered above the high end of the range of estimates (-4.5% – 0.0%).

   

• Case-Shiller Home Price Index for April came in at consensus 1.8% MoM and 21.2% YoY price increases.

   

• Consumer Confidence for June of 98.7 came in slightly below expectations of 101.0 but fell within consensus range of 95.0-104.0.

Weekly Market Report: June 24, 2022

We saw some typical bear market activity last week with equity markets continuing to churn, this time to the upside despite mounting evidence of a cyclical slowdown and global central banks chasing commodity prices. Some inflation data out of the U.K. and Germany provided some encouraging data points while other economic data made clear economies are still expanding, though at a decelerating pace. U.S. equity markets enjoyed a nice rally last week of over 6% while developed international (+3.75%) and emerging markets (+2.5%) were up but not as strong. Bond markets enjoyed further decline in interest rates while the USD lost a little ground and commodities, thankfully, did as well.

Market Anecdotes

• With the S&P 500 officially in a bear market, the key questions are how much deeper and how much longer? Depth and duration of the economic slowdown currently unfolding will be the determinant but either way, we’re on track for the worst six month start to a year since 1932.

• Wall Street analysts have been slow to adjust their year-end price targets for the S&P 500 with the S&P 500 now trading over 20% below its bottom-up consensus analyst price target – one of the widest divergences on record.

• Market and sentiment-based inflation expectations alongside inflation data continue to paint a concerning but mixed picture, particularly with a focus on headline data series.

• Some of the differences between CPI and PCE inflation include fixed versus dynamic weightings and differing data sources with the key differences in shelter and medical costs.

• Economists surveyed by The Wall Street Journal have dramatically raised the probability of recession, now putting it at 44% in the next 12 months, a level usually seen only on the brink of or during actual recessions.

• An interesting look at the origin of U.S. company profits from the BEA and Goldman Sachs does challenge some of the narratives of achieving adequate diversification by owning a broad basket of U.S. companies.

• A decoupling of U.S. consumer sentiment and unemployment has been one of the more remarkable reminders of the toxic power of inflation.

• With much attention on the health of the U.S. consumer due to the exceptional job market and household liquidity measures, it’s worth noting debt service on the part of corporations is also in a good position.

• Fossil fuel sales from Russia since their invasion of Ukraine have remained relatively stable but the composition has certainly changed and is expected to continue.

Economic Release Highlights

• Preliminary June PMI data saw broad based deceleration but remained in expansionary territory.
• U.S. Existing Home Sales for May (5.41mm) were down 3.4% last month and stand down 8.6% year over year.
• U.S. New Home Sales for May (696k) were up 10.6% over the prior month but are down 5.95% year over year.
• The average 30-year mortgage rate edged up to 5.81%, a level not seen since the advent of the global financial crisis in 2008.
• UofM Consumer Sentiment Index for June slid to 50.0, down from a 58.4 reading the prior month.

Weekly Market Report: June 17, 2022

Global central banks, inflation, and war in Ukraine combined to send equity markets to a second consecutive 5%+ decline as investors buckled up for a notable increase in the likelihood of recession. A primary driver was that the Fed made it pretty clear it had no intention of acknowledging financial conditions by stepping in to pause or ease or provide liquidity, unlike 1966 and 1987 – the only two bear markets on record that occurred without a recession in the general vicinity. Interest rates one year and shorter climbed 0.25% while maturities from 2yrs to 30yrs moved up a more modest 0.10%. Commodity markets fell 6% on the back of oil falling nearly 10% back to $109 and industrial metals were soft in reflection of global growth concerns.

Market Anecdotes

• The Fed hiked interest rates by 75bps on Wednesday, above the 50bp rate hike plan it had telegraphed at its previous meeting and made clear their renewed focus on issues being presented by headline inflation. The FOMC dot plot projections were also revised sharply higher. 
• With ample red ink to swim in this week, we’ll note some green which is clearly evident in nearly all post WWII data showing equity market returns following bear markets, 15% quarterly drops, and 20% or worse six month drops. 
• It’s been really rough sailing with nine of the last ten weeks closing out on a decline, something only three other periods can claim – 1970, 1982, and 2001. 
• The year-to-date decline in S&P Growth of -30% versus S&P Value of -15% has brought their relative valuations quickly back into neutral territory and U.S. large caps (15.4x), U.S. mid-caps (11.1x), and small caps (10.8x) overall have fallen back into fair to cheap range. 
• With inflation, and specifically the one including food and energy, now seemingly the focus of the Fed, the individual components and their trends warrant close attention. 
• Recovery in U.S. labor market participation is a key underpinning to a more muted recession scenario potentially allowing payrolls to keep growing while the unemployment rate rises. 
• Credit spreads in the bond market provide a good barometer of the overall economic anxiety level in the market and while high yield (above 5%) and investment grade (above 1.45%) are not yet at extreme levels, high yield CDS has risen to a new cycle high. 
• Investor sentiment has fallen into extreme bearish territory with 19.4% bulls, 22.2% neutrals, and 58.3% bears while LEIs and industrial production and goods orders are showing the wear and tear of inflation. 
• In an emergency meeting on Wednesday, the ECB pledged to “apply flexibility” when reinvesting PEPP proceeds and to address uneven impacts of policy normalization across jurisdictions. 
• The BoJ stuck with its ultra-doveish policy keeping its target rate at -0.1% and reiterating its 10yr JGB target yield around 0% while the BoE hiked rates by 25bps as expected.

Flash Memorandum: June 17, 2022

On Wednesday of this week the Federal Reserve increased its benchmark federal funds rate by 0.75%, the largest single rate increase since 1994. The fed funds rate now stands at a range of between 1.5% and 1.75%. Fed officials expect the Fed to raise rates to at least 3% this year, with at least half of them indicating the fed funds rate may need to rise to 3.4% this year with rate hikes expected into 2023. Due to the clear connection between monetary policy and global economics and financial markets we feel compelled to provide clients with some insights and our current view of the landscape.

The Fed has seemingly changed its tone in recent days, taking a much more assertive stance toward bringing inflation down to its target level. This hawkish pivot is remarkable in that it appears to be driven by: 1) headline inflation and 2) a single monthly data point (the May CPI report released June 10th). These two elements represent a major deviation from 40 years of Fed policy. Historically the Fed has emphasized core inflation, and the trend thereof, which excludes the more volatile categories of food and energy prices. Changes in food and energy prices are more volatile and often related to temporary factors. For instance, environmental factors can influence agricultural commodity prices and fluctuations in OPEC production targets impacts energy prices in the near-term.
Both are examples of supply side stresses unrelated to trend changes in the economy’s overall price level and therefore not historically a material factor in monetary policy decisions.

The image below shows the headline (all items) CPI index rising 8.6% for the 12 months ending in May, the largest 12-month increase since December 1981. The core (all items less food and energy) index rose 6.0% over the last 12 months, although it has fallen for the last two months including a decline from a 6.2% reading in April.

What does all of this mean and why is it important? Powell and his colleagues appear to be placing a larger focus on fighting headline inflation given trends in core data and narratives coming out of the Fed. Their preferred measure of core PCE has been declining since March.

The Fed’s words and deeds suggest there is some tangible anxiety about the overall price levels and the perception that they have been well behind the curve. Powell blurred the concepts of core and headline inflation at his post FOMC press conference this week. As a result, markets are needing to factor trends in both headline and core inflation measures with a need for both to cool for the Fed to slow down the removal of accommodation. This will require food and energy prices to decline which are being driven overwhelmingly by the conflict in Ukraine. Supply side issues across commodity markets (grains and oil) need to begin to show healthier and improving trends for headline inflation to abate. 

Increasing rig counts, refining capacity utilization, and energy alternatives to Russian oil need to materialize before the global economy weakens and unemployment begins to tick higher. Very elevated crack spreads have EIA expectations for an increase in refinery utilization to average 96% this summer is expected to take some pressure off gas prices but reduced overall refining capacity since the beginning of the pandemic has complicated the backdrop.

Additionally, Russia and Ukraine are both major exporters of wheat. The war has disrupted the normal farming and export cycles, driving wheat prices up more than 50% since a year ago. The prices of many other foods, ranging from grains to meats and oils have risen dramatically in recent months.

Rising prices mean workers experience pay cuts when it comes to real wages. Even though average hourly earnings rose 0.3% in April, the net effect is a decline in real wages of 0.6% when accounting for inflation. On a 12-month basis, real average hourly earnings were down 3% in May.

Although the market’s expectations for inflation (observable via TIPS break-even rates or 5-year forward inflation swaps) remain anchored at 3%, the University of Michigan Surveys of Consumers year-ahead inflation rate was 5.4%, up from 4.2% a year ago. The expectation for the next five years is 3.3% annually. This has clearly impacted Powell’s pivot to increasing hawkishness. Awareness of consumer sentiment becoming a major component of the Fed’s calculus suggests it needs to be scrutinized more closely by market participants, by extension. At his news conference, Powell said the Michigan survey helped push the central bank away from a 0.5% increase that had been expected only a week earlier. The Michigan Consumer Sentiment Index comes out twice each month, once in a preliminary reading, and then, two weeks later, in final form. The final Michigan reading this month comes out June 24th, two days after Powell presents his Monetary Policy report to the Senate Banking Committee. The Michigan survey is directly correlated with food and energy prices, essentially representing another pivot to headline inflation from core. 

Finally, the trajectory of Federal Reserve rate hike forecasts this year have risen from 65 basis points in December 2021, to 175 basis points in March, to 341 basis points this week. It appears markets have lost confidence in the Fed’s forecasting abilities; hence, rate uncertainty and attendant equity volatility will persist until energy and food prices begin to decline.

As calendar year 2022 commenced, consumer balance sheets were strong, and savings abundant. Corporate revenues and profit margins were also vibrant. The market is clearly pricing in declining economic activity in the form of significant compression in P/E multiples because of the inflation backdrop and increasing central bank hawkishness. The S&P 500’s P/E multiple has compressed by about 22%, nearly equal to the decline in the index.

Although recession indicators are still not flashing an imminent decline in economic growth, the odds of that occurring have risen in recent weeks. Given the Fed’s recent focus on headline inflation (which it cannot control outside of intentionally orchestrating a recession), the odds of them engineering the ‘soft landing’ have fallen,
leaving markets on edge.

There have been two bear markets in history which proceeded to fall notably after the initial ‘bear market’ 20%+ correction, 1973-1974 and 2008-2009. In both cases the U.S. economy fell into very deep and persistent recessions. If the Fed can engineer and maintain a modest economic backdrop as supply chains heal including supply side responses in both food and energy markets, equity markets (particularly emerging markets) are attractively priced when viewed over the intermediate term (1-3yrs) as the historical data below reminds us. That said, the bear market is here but potentially incomplete due to a likely decline in corporate profitability (rising rates, profit margins) and a persistent tax from high inflation.

Bond yields probably overshot in the near term given the increased odds of recession which leads us to a moderately cautious stance on credit and neutral duration guidance from an interest rate risk perspective. In the end, trading in volatile markets is exceedingly difficult and should be minimized. Minor tactical rebalancing to maintain proper asset class exposures is advisable with equity markets now officially in bear market territory and bond markets off to their worst calendar year start on record.

Market Anecdotes

Weekly Market Report: June 10, 2022

Markets took another punch in the nose last week with inflation (CP-Oh My) and ensuing central bank policy the primary driver. Whether we are again looking at a sharp repricing or looming recession remains to be seen, but equity markets are seemingly handicapping the latter given the volatility and depth of the correction, currently 19% off the early January record high. Bond markets reacted sharply to the CPI print on Thursday with both yields and credit spreads surging late in the week. Broad commodity markets were flat on the week with oil edging up slightly to close over $120, grains rallied, and industrial metals down. The USD received a flight to quality bid late in the week, closing up nearly 2% to close at nearly a 20-year high.

Market Anecdotes

• As if 2022 was short on breaking records, we’d note that we are on track so far this year to register one of the most volatile equity markets on record and one of one of the largest P/E multiple contractions on record, and without a doubt the worst start for the bond market ever. 
• Bond markets again provided little solace last week with yields rising anywhere from 10bps to 40bps, mostly centered on shorter maturities, and a notable widening in credit spreads. 
• Inflation anxiety was front and center last week with prices of energy and food, emanating purely from the RussiaUkraine war, driving both the number and sentiment. 
• There has been anecdotal evidence of a pretty sharp recovery in the semiconductor supply chain situation across the auto sector with restored capacity happening far sooner than anticipated. Daimler Chrysler noted they are back operating at full capacity. 
• ECB hawks finally got their way with Thursday’s announcement which set the table for a 25bps rate hike in July while remaining data dependent thereafter. They made significant upward revisions to their inflation forecasts (2022 5.1% to 6.8% and 2023 2.1% to 3.5%) and downgraded growth (2022 3.7% to 2.8% and 2023 2.8% to 2.1%). 
• Rising interest rates translating to rising mortgage rates which have pushed the average 30 yr fixed rate back above 5.5% has seen demand for mortgages plummet and existing home prices fall but affordability and foreclosures still paint a constructive picture. 
• A compelling way to look at the U.S. housing market is through a ‘two stage’ lens with higher mortgage rates softening demand followed by higher inventory and softening prices which would lead to a disincentive for home construction. 
• BCA noted Russian energy weaponization may seek to disrupt oil supplies in the Middle East and North Africa as well as undermine attempts to restore the 2015 U.S.-Iran JCPOA. 
• BCA noted Chinese credit data for May came in higher (better) than expected but it’s coming off an extremely low April reading and April/May combined are still below 2021 levels. 
• In a small-cap vs large-cap research note, we’d note relative forward earnings growth, valuations, and relative performance in light of recession anxiety make a decent case for favoring small-cap.