Recession, Not Inflation, Now the Market’s Primary Concern
June 17th, 2022
After months of the S&P 500 avoiding a bear market, the dual pressures of broadening inflation and an increasingly hawkish Fed ultimately broke through any remaining bullish resistance. The S&P 500 index officially closed in bear territory on Monday, June 13, closing the trading session at 3,749.63. That put the index -22% below its record high of 4,796.56 from January 3rd. On Wednesday, the highly anticipated FOMC meeting concluded where the Fed announced a 75 bps hike to the benchmark rate. This was higher than investors had originally forecast, but given last week’s inflation report, it was necessary in order to send a strong message to markets that the Fed is intent on bringing inflation under control. Volatility hit both equity and fixed income markets. Yields initially rose on anticipation of the Fed’s actions, with the 10-yr Treasury yield hitting 3.45% prior to the Fed’s announcement, but quickly retreated to 3.23% by the close on Friday as investors recalibrated their recession risks. In the end, it was another bruising week for investors, with the S&P 500 declining -5.80% for its worst weekly performance since March 2020.
Fed Steps Up Inflation Fight
Coming on the heels of last week’s scorching inflation report, the Fed amped up its efforts this week to bring prices and demand back under control. The central bank announced a 75 bps hike at its Federal Open Market Committee (FOMC) meeting on Wednesday, taking the benchmark rate to 1.50%-1.75%. The increase is the central bank’s biggest since 1994. The 75 bps hike was higher than the 50 bps hike it had signaled just a few weeks ago, and in doing so, it suggests the Fed wanted to send a clear signal that it is back on the job after being behind the curve thus far. The recent CPI reports showed few signs of inflation peaking and with demand remaining strong and the supply side still constrained, the Fed has been left with little choice but to act more aggressively. The central bank also vowed to do more in future meetings, signaling another 75 bps hike is on the table in July. New projections for year-end benchmark rates were also released this week. The dot plot, which the Fed uses to signal its outlook on interest rates shows the median year-end benchmark rate at 3.40%. That’s up from March’s year-end forecast of 1.90%. Considering the new projections, the Fed still has a lot of hiking to do by year-end. Assuming the forecast holds, more hikes are expected next year. The central bank is currently projecting a 2023 year-end median benchmark rate of 3.80% -over 2% higher than where we are today. Forecasts can change, but for the time being short term and intermediate term rates certainly look set to rise. It is the long end that may pause, waiting to see the impact rates have on the economy.
Consumers Favor Experiences Over Goods
Retail sales slipped in May as China’s lockdowns disrupted the supply of available goods. U.S. retail sales fell -0.30% month-to-month, driven in large part by a sharp -4.00% decline in autos and parts as Chinese factories were largely shuttered in April in an effort to contain a wave of Covid-19. The move prevented much-needed components from reaching automakers’ factory floors and dealer lots. Given the slim pickings at auto lots, customers decided to delay their car search for another month. Big ticket items such as electronics and appliances also fell during the month. Those items fell -1.30% with consumers simply having reached their limits following the yearslong binge starting in March 2020. With the summer vacation season now underway, gasoline stations benefited from greater volume and high gasoline prices. Sales were up 4.00% for the month and 43.2% yoy. Restaurants and bars also continued to pack in diners, ringing up 0.70% more in sales in May. Overall, if it were not for supply chain constraints in the auto sector, May’s retail sales results would have been surprisingly strong and it suggests consumers remain willing to spend even in the face of high prices.
A lot of this week’s attention focused on the importance of the Fed having chosen to increase 75 bps versus 50 bps, along with the implications for what this may mean in terms of the size and timing of future rate hikes. In raising by 75 bps and with Powell’s comments that have followed since, it is clear that the Fed is willing to accept slower or even negative growth if that is what is required to control inflation. The market desperately wants inflation tamed, which explains why the market initially rallied after Wednesday’s hike, but Wall Street recalibrated its probabilities for recession on Thursday, leading to a painful rout. Most of the microanalysis on the Fed’s hike misses the bigger point, and we’ll repeat the opinion we’ve shared before. We’re still a long way away from a neutral interest rate level–some 200+ bps at least and the quicker we get to a neutral level the better. That said, virtually all projections on the future path for rates still result in a level that is remarkably low by historical standards. Companies can operate effectively in a higher interest rate environment. Is it possible higher rates lead to a recession? Absolutely, but persistent inflation is far more damaging to valuations than a recession and with the S&P 500 now -23% below its highs, a significant amount of that risk seems priced in.
The Week Ahead
Markets will attempt to steady themselves after several tough trading sessions. U.S. economic news will be light with existing and new home sales being the highlights of the week. In international news, the EU releases PMI numbers.
Bulls and Bears
As mentioned above, the S&P 500 fell into bear territory this week. A bear market occurs when a stock index drops more than 20% from its recent highs. Somehow, bulls and bears have come to symbolize the highs and lows of the market. If it’s a bull market, it means that economic conditions are favorable, and investors are optimistic and buying in anticipation of prices rising. If it’s a bear market, it’s likely to mean that investors are selling in anticipation of prices declining. In short, bears are bad, and bulls are good.
These are interesting metaphors, and there are some theories behind how bulls and bears became mascots for the market. Please “bear” with us as we explore some history and a few ideas about the origins.
One theory states that the terms derive from how each animal attacks. A bull uses its horns and its head in an upward motion to attack, while a bear is likely to strike with its paw in a downward motion to attack. Thus, an upward thrust of a bull means stocks go up, and a downward swipe of a bear means stocks go down. Bulls and bears have also been seen as opposites due to the popularity of bull-and-bear fights that took place beginning in the 13th century and continuing into the 1700s in England, and there are historical records of bull-and-bear fighting as recent as the 1800s in California. These were fights to the death that served as entertainment to spectators until they were banned in the 1850s.
Another theory postulates that the term for a bear market was coined in the 1600s when bearskins were a popular commodity in the commercial fur trade in North America. Bearskins were traded for food, supplies, and other goods by a wholesaler known as a “bear jobber.” Sometimes bear jobbers would sell the skins before the hunt was over, introducing speculation about the bearskin market. If the hunters were successful and the supply of skins was abundant, the market makers could buy them cheaply and turn a good profit. If the hunts were not successful, the bear jobbers would have to pay higher prices for the skins they had already sold to buyers. A proverb warned not to “sell a bear’s skin before one has caught the bear.” The theory behind this origin story states that bearskin or bear jobber was shortened to bear and came to symbolize speculative investing.
Some theorize that the term for a bull market was introduced in the 1700s in association with the South Sea Bubble. Poet Alexander Pope became an investor in the South Sea Company and urged others to invest as well. He wrote the following poem – presumably prior to the bubble bursting:
Come fill the South Sea goblet full;
The gods shall of our stock take care:
Europa pleased accepts the Bull,
And Jove with joy puts off the Bear.
Pope chose to pit the bull opposite the bear as the bear’s adversary in his poem, and it caught on. The South Sea bubble was driven by speculation about the success of the South Sea Company, a British entity formed by Parliament in 1711 to help Britain increase its trade in the Americas and reduce the national debt. Parliament gave the South Sea Company a monopoly on trade, primarily the slave trade, with the Spanish and Portuguese empires. Many speculated that trade would flourish at the end of the War of the Spanish Succession, however, Spain imposed strict limits on British trade and took a percentage of the profits to boot. The South Sea Company couldn’t generate the income it needed. King George, the ruling monarch at the time, and others within the government continued to encourage investors to buy the company’s stock, thus inflating its price. When the bubble finally burst in 1720, it became the world’s most disastrous financial crash. It’s believed that Pope’s poem, and his involvement as an investor, helped the terms “bull” and “bear” become the symbols for up and down markets.