Markets, Economy, and Portfolio Management Spring 2022
In the first quarter, the S&P 500 Index corrected intraday 14.9% from its high, and on a closing basis 13% implying that the U.S. economy is in a growth scare rather than an impending recession. By quarter end, a broad rally in stocks recovered more than half this correction losses. This was the worst correction since the start of the Covid pandemic two years ago. A faster tightening cycle by the Federal Reserve, runaway inflation and Russia’s invasion of Ukraine all contributed to the stock market’s correction.
The S&P 500 could retest current correction low if inflation does not peak in Q2. Parts of the Treasury yield curve inverted, typically a harbinger of a recession ahead. The yield curve subsequently quickly un-inverted to a positive sloping curve making an argument for growth ahead not a recession. The 3 months-to-10-years Treasury Yield Curve, a more reliable indicator, remains steep signaling no recession ahead. Which way the market goes depends on the path of inflation. If the Fed through its front-loaded hikes cannot curb inflation soon then expect a recession and down market in stocks over next twelve months. Furthermore, weighing on stocks is the upcoming Mid-term election. Historically stocks correct sometime from May through October period before Mid-term election.
The bottom line, this will be a transition year for the U.S. economy but worth the pain. Does anyone really expect that transitioning from abnormal monetary policy (zero Fed Funds rate in an economy that grew at 5.7%) to more normal monetary policy will happen smoothly? In the end the U.S. economy will be better off with normal yields and rates and so will income investors.
There may be room for investors to gain from stocks later this year. The S&P 500 typically peaks 18 months after an inversion and a recession typically starts shortly after that – late 2023. It takes around a year for stocks to peak after a point of the Yield Curve inverts, and the S&P 500 usually trades higher by 15% during that period, according to JPMorgan. Following the Midterm election, this November through April 2023, S&P 500 enters its historically best return period of the Presidential cycle, with past returns strongly positive one hundred percent of the time according to the Stock Trader’s Almanac. Given inflation recedes and U.S economy avoids a recession, stocks would rally. For the time being, I am only buying stocks at lower entry levels than today’s market level. I expect to be overweight stocks again before Midterm election day.
What lies ahead for the stock market? The S&P 500 should see above average volatility and extremely limited upside until after the Mid-term election. Research by Bespoke Investment Group shows that following corrections of 10% or greater and subsequent rallies of 10% or better, stocks rose in coming quarters.
Bear markets occur near the end of a tightening cycle and not at beginning. This tightening cycle began in March and ends in 2023. Valuations fall in advance of tightening into tightening cycle which explains why S&P 500 Index Price-to-Earnings (P/E) have fallen from 23 to 19 level over last 12 months. S&P 500 Index P/E is likely to fall further to a PE of 17 associated with inflation of 4-5% and in-line with slower growth. Of course, it could decline further depending on how far the Fed needs to tighten to cool down red hot inflation. My view is the S&P 500 Index peaked on January 3, however, after the Mid-term election it could be back on its way higher again. Inflation should head lower by year-end.
The Federal Funds rate (FFR) could reach 2.75% early next year according to CME Fed Watch. Inflation is running away, and unemployment is exceptionally low, so the Fed has room for front loaded hikes now. While these actions seem restrictive, after the Fed finishes with its tightening, interest rates will still be historically low. Modestly higher consumer rates will dampen consumer demand but not choke it to death. Remember, this tightening cycle is starting from an absurd FFR of zero!
I believe the economy and corporate profits will continue grow in 2022. The economy is healthy and employment picture is extremely strong. The economy is at the beginning of its Late cycle currently experiencing stagflation. The heavy damage from tightening cycle occurs late in cycle when curve flattens and inverts. There is a lag before higher rates slowdown the economy.
Earning (EPS) are growing but at a decelerating rate, and the same for sales. Analyst lowered EPS estimates for first quarter but raise EPS for remaining three quarters. Typically, the S&P 500 turns down 6-9 months before EPS turns down. Looking forward, Analyst are projecting earnings growth of 9.8%, and revenue growth of 9.5% for 2022 according to FactSet. The bottom line is that Analyst are optimistic on corporate sales and earnings despite of headline news of war in Ukraine, hot inflation, and faster tightening cycle.
Stocks do well during an inflationary period just not in high inflationary time. The S&P 500 EPS and Revenues have grown in an inflationary environment as long a profit margins hold either through productivity gains and or by companies increasing prices. Consumers are still buying goods at higher prices, like cars, fortified by their savings, high employment rate, and wage gains. However, at one point, inflation will generate demand destruction. Consumer will hold back on purchases if the price is too high. Analyst project revenue growth of 9.5% for 2022 which is above its 5-year average.
Most S&P 500 companies citing negative impact from labor cost. Even so the estimated net profit margin for the S&P 500 for Q1 2022 is 12.1%, which is above the 5-year average of 11.2% but below last quarter’s peak of 12.4%. The market has seen peak multiple and peak profit margins for this cycle. I just hope there is not a squeeze in profit margins because that would mean stock multiples further compress.
Earnings, sales, and profit-margins must hold up this year for market to trade higher. Inflation is the key to the market. Historically, when inflation has averaged 4-6% the multiple on the S&P 500 has been closer to a Price-to-Earnings ratio (PE) of 16.7 according to CFRA.
In the past conflicts like the Russian invasion of Ukraine do not have long term consequences for investors. Russia’s economy is one twentieth of the U.S. economy. Europe is a different story because its Green Policy makes it dependent upon Russian energy. Europe is at greater risk of falling into recession than the U.S., a country that can be independent of Russia oil if it chooses to do so. China’s lockdown of major manufacturing cities, in response to its latest COVID breakout, is disrupting the supply chain again and hurting consumption. For now, Europe and China are dragging down global growth and creating inflation pressure.
The U.S economy remains in an expansion. Real gross domestic product (GDP) increased at an annual rate of 6.9% in the fourth quarter of 2021.The GDPNow model estimate for real GDP growth in the first quarter of 2022 is 1.1%. For the remaining quarters GDP is projected to grow on average 3%. Next year, TD Economics forecast U.S. economic growth of 2.2%.
The U.S. economy is going through a transition period this year. I am more in the stagflation camp over the next twelve months and not recession. Stagflations looks like 1.1% economic growth and y-o-y inflation of 8.5%! I see inflation peaking by the summer and dropping by year-end. It is difficult for U.S. economy to fall into recession given consumer strength and strong employment numbers.
Recent ISM indexes both Service and Manufacturing show expansion readings, despite ongoing struggles with supply chains. Sustained employment growth helping to alleviate labor shortages. Moreover, the March payrolls gain showed expansion numbers and the employment report improving labor force participation rate. The Labor Department reported that Continuing claims dropped to the lowest level since December 1969. Weekly jobless claims fell to lowest level since 1963 in March. Unemployment fell to 3.6% rate the lowest in over a decade. I am watching initial Jobless claims which is a leading indicator. Initial Jobless claims bottom out 34 weeks on average before the beginning of a recession. The economy must see initial jobless claims get worse for a quarter before I become more concerned about a recession. Also, the unemployment rate is a leading indicator that tends to bottom four months before the beginning of a recession. Consumer spending, derived from employment, would sink lower with higher unemployment. Sixty five percent of the U.S. economy is consumer driven. It is the backbone of U.S economic growth.
The consumer is in the best financial shape in over a decade. Household finances are healthy. Disposable personal income continues to grow at a strong pace of 5.7% rate, but inflation is eating away at consumer purchasing power and creating conditions for demand destruction. Presently, consumers are earning more and saving more. Savings rate of 5.9% and wage growth supports consumer spending in 2022 which supports corporate earnings estimates. It would be constructive for spending to see inflation peak and fall into year-end.
Inflation measured by the Consumer Price Index (CPI), a broad index, is jumping in all categories Goods, Services, Energy, Shelter, and Food. The CPI for March rose 8.5% – the highest since 1981. The CPI may peak this quarter and decline to 5.2% by year-end according to TD Economics. One Year Treasury Inflation Protected Notes (TIPs) breakeven yield is 2.61%. TIPs market saying Fed’s restrictive money policy will lower inflation by 2023. I am watching monthly change in CPI. If month-to-month inflation begins to decline to 0.3% monthly rate, then CPI is coming off boil. Tight labor conditions will keep inflation elevated.
The Federal Reserve (Fed) finally admits its way behind the inflation. To reduce inflation from current levels requires hurting demand created by removing excess cheap money from economy. Inflation is not just wage inflation, supply shortages, rents, and higher oil supply, its money supply too. There is too much money injected into the system creating inflation in most areas of the economy such as housing. The Federal reserve is now on a fast track for tightening financial conditions. Expect the next two hikes of fifty basis points each, and additional ones at each meeting until FFR reaches 2.75% in 2023. In addition, The Fed plans to shrink its massive balance sheet which further tightens financial conditions. By the end of 2023, the Fed plans to reduce its Balance sheet by $1 trillion dollars which equates to an additional 3.5% increase in tightening – that’s restrictive monetary policy. Piper Sandler research based on 61 years of data, shows eight recessions. All of them associated with Fed tightening in the vicinity of or above neutral. Only one clear exception to the rule (1994). Front ended rate hikes may undermine corporate earnings in fourth quarter as the effects of higher front ended rate hikes begin to slow economic growth sooner than later. On a constructive note, the 2-Year Treasury Note yield peaked and is falling at this time which implies rapid and open-ended rate hikes might not be the case.
The risk of a recession is higher in 2023. However, it is not a fait accompli. There are other macro-economic variables to account for to say outright the U.S economy is heading towards a recession. For example, Credit market indicators, the 3 months-to-10 years Treasury yield curve, ISM Indexes, Continuing claims, and Leading-to-Coincident Indicator all show expansion readings for now.
Portfolio strategies are closer to their neutral weighting in equities because it pays not to fight the Federal Reserve (Fed). The Fed is removing liquidity from the economy by hiking its key interest rate and reducing its Balance sheet (not buying Treasuries). The S&P 500 index has an inverse relationship to the Federal Balance sheet. When the Federal Balance sheet expands the S&P 500 Index moves higher and when it shrinks so do stock multiples. This year poses numerous headwinds for stocks and bonds.
The U.S. economy is in early Late cycle experiencing stagflation. Certain areas of the equity market have more upside than other areas. Those areas are Energy, Commodities, Materials, Technology, and Consumer Staple sectors. In addition, defensive type sectors such as Healthcare. Portfolios will remain underweight in bonds and near neutral in cash-equivalents and ultra-short bonds until the second-rate hike. Historically, by the Fed’s second-rate hike bonds become a buy.
I am rebalancing portfolios from neutral to overweight equities at the beginning of the fourth quarter before mid-term election day. The headwinds troubling stocks now should abate by then producing a strong year-end rally. Until then hold onto stocks which are the best long-term inflation hedge. Many companies have been able to pass on rising costs, and I see low real rates favoring equities.
Inversion of the yield curve does not always lead to a recession, and if it does then the typical recession is 6-to18 months away and the S&P 500 continues to rise after inversion for a while. Typically, the S&P 500 does not peak until between two and 12-months prior to the onset of a recession or 18 months after an inversion according to Canaccord Genuity.
Do not go all in on recession type investment sectors. An NDR study on crisis events concludes that stocks have seen strong gains in the following months, on average, after the initial event such as the Russia/Ukraine war. Defensive sectors have outperformed cyclical sectors during initial crisis events then cyclical sectors regain leadership months later. It is too late to buy expensive utilities and consumer staple stocks. Investors that do will be painfully whiplashed in a couple of months. Both sectors have the lowest buy ratings by Analyst. Instead, Analyst are most bullish on Energy, and Information Technology. I also want exposure to cheaper late cycle sectors such as Materials and Energy.
I am getting defensive but with areas of the market that will outperform beyond the initial downturn. High quality Large-cap Growth stocks have defensive characteristics such as dependable “earnings growth and free cash flow.” Earnings growth will become more valuable as the economy slows down. Profitable Growth stocks with free cash flow outperform after Fed hikes, after valuation compresses, and when economy slows. For instance, Technology stocks underperform most sectors at the beginning of a tightening cycle; however, the tables turn by twelve months outperforming early defensive leaders in the tightening cycle. In addition, defensive Healthcare stocks, generating reliable sales growth, selling at reasonable prices, should outperform as the U.S. economy slows down. Healthcare is interest rate insensitive.
I am buying Growth stocks selling at reasonable prices (GARP) that are growing dividends. A real hedge against inflation is an investment that is going to increase cash flow over time and use cash flow to raise its dividend. Dividend growth is an inflation hedge because it helps maintain purchasing during inflationary periods. I am buying GARP stocks in the sectors I mentioned.
Energy is my favorite sector. Energy is one of the top performing sectors when the Fed tightens. Moreover, oil prices are highly likely to remain high into 2023 as Europe and the U.S. wean themselves from Russian oil. Over the next few years, the West will try to become independent of Russian energy exports. Even if more supply hits the market, U.S. energy companies can be profitable above $50 per barrel.
Given my view that the economy is slowing in the face of tighter financial conditions ahead, I am favoring Large-caps over Small-caps. Large-caps are more defensive than Small-caps. Small caps are a leading indicator for large caps. Small caps corrected 20%, a bearish signal forecasting slower economic growth. Small-caps underperform when the 2-years Treasury yield increases, and yield curve flattens. When the 2-Year Treasury yield peaks it is time to buy Small-caps again given no recession lies ahead.
I have cut our exposure to European equities and Emerging Market equities to lowest weighting in over a decade as I see the energy shock hitting both regions hard. China’s growth is also slowing because of its mandatory shutdowns of major manufacturing cities to stop the spread of Covid.
Rising rates are a concern for bonds because bond prices decline as rate rise. I am not exposing bond component of portfolio to interest rate risks. I am investing in areas of the bond market that have low interest rate risk such as short-term credits, Senior Loans, and Floating Rate Notes. I can get income that exceeds the 10-Years Treasury bond yield with lower principal risk. My largest fixed income position is Investment grade floating rate notes. Unlike bonds that pay fixed rates of interest, floating-rate notes pay interest at rates that adjust periodically, based on current short-term interest rate. They offer potential inflation protection and a hedge against rising rates which makes them less likely than most fixed income investments to lose value when rates rise.
For high current income that most areas of bond market cannot match, I am buying Preferred stocks. Preferred stocks have interest rate risk like bonds, but some offer floating rate option. Preferred stocks are mostly issued by investment grade banks.
My stagflation risks holdings include energy, Investment Grade Floating Rate Notes, Commodities, and Gold. Gold prices tend to rise in times of geopolitical risk and inflation. Gold usually moves with real yields which consider inﬂation. If inﬂation rises and real yields move lower, Gold typically moves higher. I own Energy, materials, and commodities as inflation hedges. Commodities rise in value, as prices rise, and the same for material stocks.