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Cold Consolidation — Week of January 17, 2022

Written by Steve Orr, Chief Investment Officer, and Mark Frears, Investment Advisor

index wtd ytd 1-year 3-year 5-year index level
S&P 500 Index -0.29 -2.11 24.57 23.45 17.55 4,662.85
Dow Jones Industrial Average -0.88 -1.13 18.03 16.79 15.08 35,911.81
Russell 2000 Small Cap -0.79 -3.67 1.29 15.79 10.90 2,162.46
NASDAQ Composite -0.28 -4.79 14.35 29.66 22.92 14,893.75
MSCI Europe, Australasia & Far East 0.19 -0.10 8.59 12.71 9.56 2,337.99
MSCI Emerging Markets 2.58 2.09 -6.22 10.52 9.81 1,254.40
Barclays U.S. Aggregate Bond Index -0.29 -1.82 -2.47 4.11 3.11 2,312.21
Merrill Lynch Intermediate Municipal -0.43 -0.93 -0.01 3.73 3.35 317.25

As of market close January 14, 2022. Returns in percent.

Cold Consolidation

Winter weather is finally in full swing across the Lower 48. Colder temps are also taking hold in the markets. Fundamental reason for the chill: worries over lower growth and inflation. Why: fears that the Fed may tighten too fast, and China will loosen too slow. Now that we have summarized about four thousand headlines for you, let’s dig in to the “why.” 

Remember the Fed implemented two “tools” to add stimulus in the early stages of the pandemic. First was quickly taking overnight interest rates from 1.5% to zero. Second, the Fed kicked off another round of Quantitative Easing, QE for short, which is a fancy term for buying Treasury and mortgage bonds. The Fed has repeatedly said it will stop the QE buying before raising overnight interest rates. The QE buying should stop by March, and markets expect the Fed to raise rates one-quarter of a percent then. 

Minutes taken from each Federal Reserve Open Market Committee meeting are released several weeks after each meeting. Most are given a cursory glance, and usually confirm Wall Street’s suspicions about Fed policy. Not so the December minutes released January 5. Traders were surprised to learn that Committee members discussed reducing the size of the Fed’s bond holdings. The surprise was, well, more surprising, because Powell had said in his post-meeting press conference that reductions were discussed. Reducing the size of the balance sheet would remove excess reserves (money) from the banking system, aka “taking away the punch bowl.” That would be a third step toward tighter financial conditions. Stocks perform better under easy (low rate, easy borrowing) money conditions. 

Don’t Fight the Fed

The mantra of not fighting the Fed was learned the hard way. 1994 resurfaces in our memory at least once per week. That year the conventional Fed wisdom was quarter point increases and slow, deliberate changes. One increase in February – okay, that hurt a little. Then Greenspan and company raised rates another quarter point between meetings and followed that up with a half-percent increase. Bonds and stocks tanked, which hurt a lot. The Fed continued to raise rates in the face of 2.5% inflation, finishing 1994 at 5.5%. 

Futures markets are pricing three to four rate increases this year. Will this be a repeat of 1994? We do not think so. The Fed has improved its public communications. Markets have had plenty of warnings that the end of QE and rate increases are on the way. The Fed also recognizes that inflation is not going back to 1.5% any time soon. 

We think the call for four rate increases may be overdone. The rate of price increases is likely to slow by midyear. The most likely path for the Fed this year is two quarter-point increases by the middle of the year, stop to check inflation and economic growth, and perhaps another quarter-point increase in the fall. We realize we are at the low end of rate projections in this scenario. However, omicron already crimped holiday sales (see below) and will impact first quarter growth.

And this latest variant may just be getting started in China. Monetary conditions were easing in response to real estate problems. We think additional easing and interest rate cuts could be on the horizon. We know of only four cities in lockdown in China at this writing. Bear in mind that covers over 20 million people. If lockdowns spread to the ports, the supply chain improvement story is pushed back at least another quarter. 

Still Going 

Will the money you have today be able to buy what you need in the future? The Consumer Price Index (CPI) purports to measure changes in prices for a basket of everyday goods, rent and gas. Headline CPI came in at 7% when compared to the same period last year. This was in line with expectations, but this is the highest reading since 1982. Core goods prices rose the most, with used cars, new cars and apparel leading the way. Core services were a bit lower than expected (fewer folks buying hamburgers) and shelter prices decelerated mildly. A year ago, CPI was only rising at 1.4% YoY, and now we are at a 5.6% pace. This is surely a forecasting miss by the Fed. Overall, inflationary pressures continued at the same level from November, and the question on people’s minds is, when this will start to abate?

The Producer Price Index came out last Thursday and was slightly below November’s reading. Year-over-year, prices paid by producers for raw materials rose 9.7%, versus 9.8% last month. It is a good sign to see decelerating core goods prices (+0.5% in December vs. +0.8% in November), and slower core services prices (+0.2% in December vs. +0.6% in November). The costs sustained by companies producing goods and services have not only been higher due to labor costs increasing, but also the ability to obtain materials. 

Whether the companies will be able to pass these increased costs to the consumer is interesting on both sides. Companies’ margins are in good shape due to low cost of funds and demand for their products. Will these increased costs cause margins to be squeezed or will the products have elevated prices to the consumer? Producer price changes tend to lead CPI by twelve to eighteen months, so stay tuned. 

On January 28th, the monthly update for the Personal Consumption Expenditure index will be released. This is the Fed’s favorite measure of inflation. In November, this came in at 4.7%. The FOMC’s December 2021 quarterly economic projections show expectations of 2.7% for 2022, 2.3% for 2023 and 2.1% for 2024. The next release is set for January 28, 2022, with market expectations looking for a 4.8% reading. Again, it is probably time for the Fed to raise its forecasts.     

Consumer

Earlier this month, the Fed released their December 2021 Survey of Consumer Expectations, showing an overall positive view by consumers on economic growth, inflation and job prospects. During the pandemic, most people were able to increase savings, pay off debt and put themselves in a better financial position.

The G.19 Consumer Credit report for November showed an increase of a record $40 billion. Given the state of the consumer, they are comfortable with their job prospects, and willing to take on more debt. Revolving credit (mostly credit cards) rose by $19.8 billion in November, its largest increase on record. Nonrevolving credit (including student loans) increased $20.2 billion, the largest gain in six months, to an all-time high.

Retail Sales release showed a lower-than-expected outcome for December, although sales activity is still 19.2% above pre-Covid (February 2020) levels. Consumer spending only grew in two of the thirteen tracked categories, compared to growth in ten categories in November. The largest monthly declines were in furniture (-5.5%), clothing (-3.1%), department store general merchandise (-7.0%) and non-store goods (-8.7%). The only positive categories were building materials and miscellaneous. Most likely this lower spending is caused by weaker consumer sentiment due to inflation news and omicron effects.

Happy Season

Yes, it’s earnings season again: those seven weeks when companies turn in their financial report cards to investors. Leading off the unofficial start last Friday were three of the big banks. Citi, Wells and J.P. Morgan all reported better-than-expected earnings and gave upbeat outlooks on their businesses and the economy. BlackRock also beat and reported its assets under management crossed $10 trillion. 

Financial firms make up most of the 39 S&P 500 members reporting this week. Goldman Sachs, Schwab, PNC and Mellon are on the dock today. Tomorrow we will get an idea of consumer activity from Procter & Gamble. On the transportation and supply chain front, Union Pacific and J.B. Hunt will also report. 

For the first time in five quarters, analysts have lowered estimates. Per Bespoke Research, earnings forecasts for the fourth quarter were cut in Consumer Staples (-29%), Utilities (-25.3%), and Materials (-8.8%).  Energy is still a star – its companies have seen their earnings estimates rise by 17% over last year’s fourth quarter. Two themes we expect to hear from corporate management: workers are hard to find, and costs keep going up. 

Wrap-Up

Grab a stock chart, any chart. Most are consolidating just below recent highs. Only the Dow Transports seem to be riding downhill, thanks to slipping trucking and rail stocks. The Fundamental picture of omicron drag supply chain inflation and central banks is not going to clear up in the next few weeks. Technically, both stocks and bonds are either in a neutral trend or oversold. 

We are at the end of a thirty-year Bull market in interest rates, in the middle of a long-term Bull in stocks, and possibly at the beginning of a new Bull in commodities. Rising rates will not dent the broader Bull, but high-flying no-revenue tech will continue to be challenged. This is an excellent time to check on your tools, financial plan and cold-weather gear. Patience will be rewarded. 


Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. Mark Frears is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Science from The University of Washington, and an MBA from University of Texas - Dallas.

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