By Rob Edel, Chief Investment Officer | Written as of August 12, 2022
Highlights this Month
- Is the stock market rally sustainable?
- Providing clarity in a period of many unknowns.
- Recession fears are becoming harder to ignore.
- How much tightening will be required to tame inflation?
- A few factors continue to surprise the upside.
July in Review
Markets largely went from a sea of red in June to fields of green last month, as both stocks and bond prices turned higher. With the possible exception of Chinese equities, most global equity markets posted positive returns last month, with the Canadian S&P/TSX index up 4.7% (total return in Canadian dollar terms). U.S. stocks did even better, posting their best monthly returns since 2020, with the S&P 500 up 9.2% (total return in U.S. dollar terms) and the tech and growth-heavy Nasdaq 100 up 12.6%. While bonds have weighed on balanced portfolio returns so far in 2022, 60/40 investors (investors allocating 60% of their portfolio in stocks and 40% in bonds) reaped the added benefits of strong bond returns as yields declined last month. According to Bloomberg, investor portfolios comprised equally of global stock and bonds suffered double-digit losses in both the first and second quarter but gained nearly 9% in the first month of the third quarter.
Is the stock market rally sustainable?
After such a strong month, investors wonder if stock prices have bottomed out and the bear market has run its course. Bear market bottoms historically occur once investor sentiment reaches its nadir and investors have sold all they have to sell. This so-called capitulation was evident last month, as a new survey by Bank of America showed that investor risk levels plummeted to levels last seen in October 2008. Also exhibiting capitulation-like tendencies were high fund manager cash levels and the lowest equity allocations seen since April 2009.
Macro institutional research shop Strategas is not so sure the wind has shifted in favour of a new bull market, however, as market breadth is still not wide enough for their liking. While 75% of S&P 500 stocks were trading above their 50-day moving average in early August, Strategas believes 90% is the critical threshold level required before the “all clear” signal can sound. While the current rally may feel impressive, it is still average compared to past bear market rallies, and the recent surge in tech stocks has been modest by historical standards.
While we concede sentiment did get somewhat bearish (which is bullish?), we tend to side with Strategas in believing history will show market action in July was a bear market rally rather than signs the market has capitulated, and a new bull market has already started. Why? First of all, while there were some signs that market sentiment had reached tough levels, other statistics fail to line up with bottoms reached in past bear markets. P/E multiples have compressed, but at around 16 times in mid-July, valuations are still pricey compared to average bear market bottoms of approximately 11 times. Additionally, while the federal funds rate has moved up, it is still well below levels seen in past tightening cycles where overnight money has averaged over 5%.
Providing clarity in a period of many unknowns.
As for market volatility, stock prices have remained positively tranquil, with the VIX in the low to mid-20s, though we concede bond price volatility has been more problematic. However, credit spreads haven’t been the issue for fixed income investors, as both investment grade and high yield spreads have remained well below levels seen in past market troughs. And finally, with the unemployment rate at 3.6% (going down to 3.5% in July), it’s hard for investors to become too bearish when jobs are so plentiful. The summer months can always provide surprises as trading volume dwindles and stock prices become easier to push around. We suspect that we witnessed some of this lack of market liquidity last month, along with the growing narrative that lower inflation and slowing economic growth will enable central banks to pivot from a tightening cycle to an easing one early next year. For this to happen, however, inflation has to ease to a level acceptable to central banks before the economy slips into a recession and takes corporate earnings down with it. There are many unknowns, so, we plan to dig a little deeper into the issues this month.
Central banks, like the Federal Reserve and the Bank of Canada, are trying to find a balance between engineering a decline in inflation back to a target range of 2% to 2.5% without causing a recession. Based on their current commentary, they view a recession as the lessor of two evils, but markets justifiably question their resolve based on past behaviour. Nowhere is the battle more evident than in the media. While stories of inflation in the financial press looked to have peaked in June, they remain elevated. At the same time, recession stories have surged, even above March 2020 levels associated with pandemic lows. Recession fears have also become more prevalent on corporate earnings calls.
Recession fears are becoming harder to ignore.
With second quarter U.S. GDP declining 0.9%—the second quarter in a row of negative economic growth— recession fears have become hard to ignore. While two consecutive quarters of contracting growth put the U.S. economy in a technical recession, the National Bureau of Economic Research (NBER) is responsible for making the official call, usually well after the fact. So far, it’s unclear if the NBER will concur quite yet. While total real growth has been negative, consumer spending and industrial production remain positive, and personal income and the job market remain robust. Financial indicators also remain mixed. While stocks were discounting a 91% probability of a recession in June, J.P. Morgan shows that the recent rally in the S&P 500 has trimmed this to only a 51% probability in early August. Credit spreads and interest rates continue to discount less than a 50% probability, though flattening and inverting yield curves have recently pointed toward a gloomier outlook. Also indicating trouble for future growth have been base metal prices, which are currently discounting an 85% probability that the NBER will need to make the recession call soon.
It has been a bit of a mixed bag and a challenge for the Fed to know what to do. The Fed has been raising rates to slow inflation, and parts of the economy are softening. Housing is susceptible to interest rates, and higher mortgage rates have predictably slowed home sales, with price declines likely to follow in short order. Industrial production also looks to be weakening, with ISM manufacturing numbers falling towards, but not yet in, contraction territory. Inflation, however, is the key. If inflation remains sticky, the Fed must keep pushing rates higher. If inflation proves transitory, it leaves open the possibility that the Fed will be able to pivot away from a tightening monetary policy and either keep rates steady or start cutting them. The market expects the Fed will continue to increase rates next year before pivoting to rate cuts. Strategists such as Morgan Stanley are not so sure, expecting the Fed to hike rates to 3.6% and keeping them there until 2024.
How much tightening will be required to tame inflation?
The Fed is more in agreement with Morgan Stanley, forecasting that rates will keep rising next year before starting to recede in 2024. As of July 31st, the market was discounting overnight rates at the end of next year would be about 1% less than what the Fed was forecasting. It’s a moving market, however, as pricing for December 2022 fed funds futures (the level the market expects overnight rates to be at the end of 2022) declined ten basis points after the July Federal Open Market Committee meeting and another ten basis points after the weak second quarter GDP release. Alternatively, the February 2023 fed funds futures were moving in the opposite direction in early August, rising 32 basis points from the end of July to 3.6%.
In fairness, it’s not an easy task the Fed has to manage. The market and the Fed are trying to determine how much tightening is going to be required to tame inflation without, if possible, creating a recession. Bridgewater highlights not only the difficulty of this but perhaps a bit of a disconnect in the market’s pricing of this difficulty last month. With headline CPI above 9% and 10-year inflation breakeven rates closer to the Fed’s 2% target, the market appears to be giving the Fed credit for being able to control inflation in the future. However, when looking at equity returns, most of the decline in stocks this year is attributable to the increase in yields, with earnings now being discounted at higher rates. Earnings are, in fact, still forecasted to move higher this year and next. So, how likely is it that the Fed will be able to control inflation—presumably by slowing economic growth—but earnings will be unaffected? That is essentially the bet that markets were making last month, as bond yields and fed funds futures were starting to discount slower inflation and a potential economic slowdown, but stocks were apparently okay with the impact this might have on earnings.
History would indicate this is a bad bet. According to Morgan Stanley, leading indicators and earnings tend to move in tandem, and the bank believes earnings are likely to follow with leading indicators recently turning lower. Strategas concurs, using tight correlations between U.S. Manufacturing Purchasing Managers Index and Small Business Earnings to make the case that S&P 500 earnings are at risk of rolling over.
A few factors continue to surprise the upside.
It’s not an exact science, however, and the impact of the slowing economy on earnings can take several months to play out. Despite concerns around slowing growth, a strong U.S. dollar, higher wages, and soaring input costs, second quarter earnings have continued to surprise the upside. Even companies missing estimates have been given a rare pass by the market, according to Truist Investment Advisory Group and FactSet. While companies falling short in the first quarter experienced an average price decline of 5.4%, second quarter laggards experienced an average price increase of 1.2%. Traders appear strangely unconcerned with earnings right now; good thing because the tide is slowly turning. According to Strategas, second quarter earnings growth is running around 8.4%, but only because big cap oil companies have played a big part in propping them up. Excluding the energy sector, Strategas believes S&P 500 earnings would be down 2.3% in the second quarter. Estimates for 2022 and 2023 have started to turn lower, and we suspect further trimming is likely.
Wall Street is starting to get more pessimistic, despite the rally in stock last month. According to Sundial and Bloomberg, net price target and EPS upgrades minus downgrades have inflected downwards, and IBES/Refinitiv report analyst upgrades now represent less than 50% of new estimates for S&P 500 stocks. On a rolling 20-day sum, Strategas reported in late July that the number of companies with lower analyst price targets approached the 2,500 level. Companies themselves are starting to lose faith, with Duke University’s CFO Optimism Index recently turning lower.
Inflation remains the fundamental variable for markets. It’s not so much a question of whether inflation will start to recede but when and by how much. Jefferies believes higher commodity prices were a significant driver of inflation, but that it has already peaked and will start to decrease rapidly. Same for supply chain dislocations. Yet, housing and labour are more problematic. The labour market is still very tight, and wages continue to increase, while low vacancy rates mean rent costs could also keep core CPI from moving back down to the Fed’s 2% target.
Despite solid wage growth, even higher price inflation means workers continue to lose ground as inflation deprives them of their purchasing power. This loss is the primary reason consumer confidence has inflected dramatically lower and inflation-adjusted retail sales have flat-lined. That is how stagflation works and why the Federal Reserve cannot standby idly. We think the market is misjudging the Fed’s resolve in fighting inflation, and the Fed will keep rates higher for longer. While the market may have already discounted the negative impact this will have on the economy and stock prices; it’s also possible it has not, and lower earnings will be the driver for the next leg down in the bear market. Negative positioning could give this bear market more fuel to run higher as traders put cash back into the market, but misjudging the Fed’s resolve in taming inflation could also send them back to the sidelines.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.