MARKET COMMENTARY

Stocks Fall as Fed Grows More Hawkish

Markets slipped this week as investors awakened to an increasingly hawkish tone from the Federal Reserve. Stocks began their sell-off on Tuesday following comments from Fed Governor Lael Brainard, typically considered one of the most dovish Fed members, who said the central bank needs to shrink its balance sheet rapidly to drive down inflation. Her comments were followed by San Francisco Fed President Mary Daley, a fellow dove, who compared high inflation with unemployment, saying that higher prices are “as harmful as not having a job.” The release of the Federal Open Market Committee (FOMC) Minutes on Wednesday only reinforced those views by giving color to each member’s views during their meeting in mid-March. Despite the strong demand for goods and services, this week’s economic news did little to inspire bullish confidence.  St. Louis Fed President James Bullard capped things off on Thursday by suggesting that the Fed was behind on its mission of taming inflation and supporting larger and faster rate increases. With investors keeping a wary eye on higher rates and with Q1 2022 earnings season about to begin, the S&P 500 slipped -1.27% for the week.

FOMC Minutes Provide Investors with the Honest Truth 

The FOMC Minutes provided the greatest clarity to date on how the Fed will fight inflation using a combination of rate hikes and quantitative tightening. The minutes virtually assured a half percentage point, or 50 basis points (bps), interest rate increase in May. The minutes also indicated that the Fed will allow $60 billion of Treasuries and $35 billion in mortgage-backed securities to “roll-off” their balance sheet each month. To understand this impact, one must understand that the Fed is a large source of demand in the bond market, which keeps rates down when they are adding to their portfolio. The decision to reduce their portfolio effectively reduces demand which causes prices to fall and interest rates to rise as a function of the Fed no longer replenishing bonds that are maturing each month. The Fed has been forthright in their intent, yet there has been a contingency of investors betting that the uncertainty over the Russia/Ukraine war would buy them more time with cheap money. This week, the Fed used a highly coordinated series of speaking engagements to reorient investors to their increasingly hawkish forecast. The Fed’s March forecast had penciled in six 0.25% interest rate hikes, which would have brought the benchmark Fed funds rate to 1.90% by year-end. The new messaging now suggests that at least two 50 bps hikes are in the works, which would bring the forecast to 2.40%. While this is not high by historical or absolute standards, investors are now concerned the Fed will blow past that figure given the aggressive shift in tone. According to the CME FedWatch Tool, a barometer used to assess the market’s expectation of potential changes to the Fed funds target rate, the odds of a year-end Fed funds rate of 2.50%-3.00% stands at 67.40%. The odds of that benchmark rate stood at 0% a mere month ago.

Trade Deficit Holds Steady

The U.S. trade deficit held relatively steady in February, following a record high in January. Both exports and imports climbed as impending conflict in Ukraine pushed up commodity prices. In February, imports rose 1.30% to $317.8 billion, while exports grew 1.80% to $228.6 billion. U.S. exports were driven by demand for industrial supplies, including fuel and coal, which increased by $1.7 billion month-to-month. Pharmaceutical exports, such as Covid-19 vaccines, rose by $1.3 billion. High, pent-up demand for international travel also boosted exports. U.S. travel, which is considered an export of services, rose $1.2 billion as international travelers returned to U.S. cities and resorts. On the import side, imports of crude oil rose to $1.9 billion while “other chemicals” increased $1.2 billion. That helped to more than offset a drop in imports of vehicles amid tight supply and a worldwide chip shortage. Although demand for goods has been strong, a shift to services appears to be underway as we head into summer.

A Tale of Two Service Sectors

The U.S. service sector continued to pick up steam in March, fueled by a sharp drop in Covid-19 cases from the Omicron peak in January.  A strong labor market has kept consumers spending despite the high inflation.  The ISM Services Index hit 58.3 in March, up 1.80% month-to-month. Numbers above 50 indicate expansion in the services sector, while numbers below 50 indicate contraction. It was full steam ahead on many fronts, with growth in new orders, business activity, and exports more than offsetting high raw materials and labor costs. Activity in the Chinese services sector, however, was a different story as Covid ravaged consumer spending under a wave of lockdowns. The Caixin China Services Purchasing Managers’ Index (PMI), which focuses on small firms, nosedived to 42 in March from 50.2 in February. Contact-intensive services sectors such as transportation, hotel, and catering took the brunt of the drop in demand. April will be another challenging month for the services industry as some 23 Chinese cities are under total or partial lockdown, affecting an estimated 193 million people in areas accounting for 22% of China GDP. Considering the wave of Covid infections and China’s zero-Covid strategy, it looks like the economy will have a steep wall to climb in order to hit its 2022 GDP forecast of 5.50%.

Final Thoughts

While the Fed may have lacked some credibility on inflation throughout 2021, you can’t say that the Fed hasn’t warned investors of late. They are going to move aggressively. The Fed minutes and this week’s carousel of Fed official commentaries should have dispelled any notion that the Fed is going to move tentatively by any vestiges of investors who may have hoped otherwise. We’ve been saying for some time that investors need to come to grips with this reality, and the market’s reaction this week suggests they’ve started to acknowledge this to be true. Aggressively raising rates comes with risks to be sure. It increases costs, impacting corporate profitability, hiring, demand, and ultimately whether the economy expands or contracts into recession. Once one acknowledges this increased risk and the probability of a recession and falling stock market along with that, it then begs the question of whether one should follow the Fed’s lead and sell their portfolio altogether in order to wait it out. After all, the yield curve has inverted (short term rates are higher than long term rates), and this has been a pretty good predictor of future recessions. There is a good basis for believing what the yield curve is saying. If markets are efficient, and knowing that the Fed is going to explicitly raise the short end of the curve, then the market prices this in accordingly for short-term bonds. At the same time, the market also believes the Fed will kill the economy by raising short term rates, which keeps the demand high for longer term bonds and prevents them from rising like the short end. Poof, an inverted yield curve, and since an inverted yield curve has predated the last six recessions, this seems pretty compelling evidence that a recession is in the future. It is not quite so simple in practice, however. First, we don’t believe that timing the market works. One might get lucky but over multiple attempts, the odds are heavily stacked against an improved position by jumping in and out. Furthermore, the tax impact (for taxable accounts) more than offsets the benefit of doing so (on a probability adjusted basis) over the longer term. That caveat aside, the bigger problem is that if we use the yield curve as our timing trigger, we find that it is not particularly helpful. The reason is because the average length from time of inversion to recession is nearly 21 months. This has been as short as 10 months and as long at 24 months. More importantly, the average cumulative return on the market, using the S&P 500 as the proxy, is nearly +20% between the time the yield curve inverts and the time the recession starts. Experience has taught us that usually when markets correct, they rarely correct back to the level they were when you first suspected they were going to correct. This is not intended to be a “feel good” or a “hold the line and ignore reality” message. It just makes statistical sense if you like what you are holding to begin with. While the market averages may decline in reaction to recession concerns, it is important to also realize there is a rotation occurring between styles at the same time – value is outperforming growth. Depending on the particular market capitalization level one looks at, growth declined between -13-16% in Q1 2022, while value increased approximately +1.5-4.5%. Our portfolios won’t be immune to the overall market decline should a recession occur (because we are broadly diversified), but we are more value oriented on average which is defensive in this environment.  Lastly, market concerns over interest rates tend to be overly pronounced, and we truly look at shorter term volatility as an opportunity. Inflation, supply chain problems, and Covid will all work their way out eventually, but the market had misread the Fed, and with the handwringing that is still yet to come, we’ll finally have some opportunities to pick up some long term investments at values that we’ve not seen for some time. We’re probably not ingratiating ourselves by saying that we’re enthusiastic about the volatility, but that is about the size of it. Inflation is not going to work itself out overnight, but patience during any squall ahead should be rewarded in the long run.  

In summary, market volatility returned once again to kick off the first full week of Q2 trading as Fed officials signaled aggressive tightening is ahead. Although the market has been fully aware the Fed would seek to hike rates, they seemed assured the central bank would generally stick to its dovish Fed funds forecast of 1.90%. However, persistent inflation seems to have thrown a wrench in those plans with the war in Ukraine pushing up commodity costs and China’s continued zero-Covid strategy hampering supply chains once again. Eyeing the risks, it’s no surprise bulls opted to take their late Q1 2022 gains off the table in sectors that underperform in rising interest rate environments, including tech growth stocks and bonds. The next big hurdle for bulls lurks around the corner with the Q1 2022 earnings season kicking off next week. Earnings, guidance, and margins will be top of mind as bulls look for more reasons to buy amid challenging market headwinds.