World to markets: slowdown in progress — Week of July 18, 2022
Strategy and Positioning written by Steve Orr, Chief Investment Officer; and Essential Economics written by Mark Frears, Investment Advisor
|S&P 500 Index||-0.91||-18.27||-10.11||10.55||11.40||3,863.16|
|Dow Jones Industrial Average||-0.16||-12.97||-8.82||6.84||10.03||31,288.26|
|Russell 2000 Small Cap||-1.40||-21.78||-19.44||5.02||5.38||1,744.37|
|MSCI Europe, Australasia & Far East||-3.49||-21.87||-20.25||0.52||1.71||1,784.89|
|MSCI Emerging Markets||-3.33||-20.16||-26.21||-0.48||1.06||965.45|
|Barclays US Aggregate Bond Index||0.56||-10.09||-10.70||-0.71||0.92||2,117.44|
|Merrill Lynch Intermediate Municipal||0.33||-6.41||-6.73||0.23||1.64||299.59|
As of market close July 15, 2022. Returns in percent.
Strategy & Positioning
— Steve Orr
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.
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.
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.
Weekly surveys and market data are following Europe’s descent from slowdown toward recession. We are not confident the Fed can slow down its rate increases in time to avoid the driving-into-the-recession ditch. Our dashboard still has some green spots, but the yellow caution lights are keeping us neutral for now.
— Mark Frears
Are you a fast walker? Do people have a tough time keeping up, or are you the one slowing everyone down? Are you done eating before everyone else, or are you the last one? We all have our own speed, and they may be different given different activities. I walk fast but am content to sail a boat versus speed around in a runabout. I have always read fast and have to make myself slow down and take notes when reading material that I want to glean more from. Bottom line, our pace may vary based on what we are doing.
The markets are trying to determine whether consumers are more worried about inflation or a coming recession. The first glimpse we had last week was from the Consumer Price Index (CPI), and it came in mostly hot. While the overall number was the highest in 41 years, the core has now come down to 5.9% on a year-over-year basis, from a peak of 6.5% in March.
It has been very nice to pay under $4 per gallon at the pump. That would have been ridiculous to say a year ago, but it is an improvement. That was starting to be apparent in the UofM Consumer Sentiment longer-term inflation metric as it fell to 2.8% down from 3.1% last month. Keep in mind that inflation is a lagging indicator, yet consumer expectations are huge in their spending habits. Food and energy are significant parts of our spending, but if you look at the big picture, other items have fallen in price. From a Wall Street Journal tracker, smartphones are cheaper by 20% this year, televisions’ cost fell 12.7%, and college tuition is up only 2.2%.
The Producer Price Index (PPI) also came out this week and exceeded expectations, coming in at 11.3% on a year-over-year basis, up from 10.8% last month. This shows producers are still under pressure from higher costs, especially energy and wage related, although year-over-year core PPI was at a seven-month low in June. So far, they have been able to pass along these higher costs to consumers, but inventory buildup is showing demand may be slowing.
While we only see part of the picture with Retail Sales numbers, they were higher than expected and show the consumer is not out of the picture yet. Spending grew in nine out of 13 categories in June, versus only five of 13 in May. Business Inventories were up slightly in May, reflecting improving supply chain and somewhat slower demand.
The State Street Investor Confidence measure has been lower in six of the last seven readings yet remains well above 2018 and 2020 levels. This shows they are still willing to hold risky assets despite the rocky 2022 start.
While the purchasing power of consumers is shrinking, in lower real (inflation-adjusted) wages, there is still a positive in the strength of the US Dollar (USD). We continue to see faith in the US through investment in USD-denominated assets, making it cheaper for consumers to buy imported goods. The headline you saw on this last week was the parity of the USD and the Euro. It has been twenty years since this last occurred.
Outside of corporate earnings, the next most anticipated event will be the July 26-27 Federal Open Market Committee (FOMC) meeting. It is a foregone conclusion that they will raise the overnight Fed Funds (FF) target rate by 75 basis points (bp), even though there was talk of a larger move after the CPI release and the Bank of Canada’s move of 100bp. Fed talking heads quashed that quickly and FF futures adjusted back down to fit a 75bp increase. Given the FOMC’s vocal attention to fighting inflation, futures markets project a further 125bp in hikes this year, on top of the July move.
The Fed’s Beige Book, published last week, is a current snapshot of economic activity in the US. Given their rate hike strategy intended to slow demand, they will see some “positive” news in the report. Three regional districts showed growing signs of slowdown in demand, five showed an increased risk of recession, and four districts saw economic growth either slowing or in decline.
One topic of discussion around these rate hikes is whether they should take the “shock-and-awe” approach with larger moves or continue their gradual pace. In previous years, the FOMC did not take the initiative on communicating future moves and may have been concerned that a larger move would shock the markets. These days, the talking heads and leaks to the WSJ help manage expectations. I believe the best rationale for a slower pace is that they do not really know how many hikes it will take to slow demand, and not start a recession. Tune into the press conference on the 27th to see how they manage expectations going forward.
While you may have one pace for particular tasks, you can accelerate and decelerate as well. The economy is decelerating, but at what speed? That we cannot accurately tell due to different impacts on different demographics. The mix of economic and inflation news still shows an improving picture, with demand slowing some and future inflation projections declining.
|Upcoming Economic Releases:||Period||Expected||Previous|
NAHB Housing Market Index
|19-Jul||Housing Starts MoM||Jun||2.0%||-14.4%|
|19-Jul||Building Permits MoM||Jun||-2.7%||-7.0%|
|20-Jul||Existing Home Sales||Jun||5,370,000||5,410,000|
|20-Jul||Existing Home Sales MoM||Jun||-0.7%||-3.4%|
|21-Jul||Philadelphia Fed Business Outlook||Jul||0.0||(3.3)|
|21-Jul||Initial Jobless Claims||16-Jul||240,000||244,000|
|22-Jul||S&P Global US Manufacturing||Jul||52.0||52.7|
|22-Jul||S&P Global US Services PMI||Jul||52.5||52.7|
|22-Jul||S&P Global US Composite PMI||Jul||N/A||52.3|
Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. 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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