Sentiment is changing. This shift is evident at the grocery store checkout, at the gas pump, and most recently, in the financial markets. January opened on the heels of a still robust investment environment; the unknown, however, was quickly approaching in the form of monetary policy reversals, making short memory of the last two years’ market performances.
Granted, 2022 opened with uncertainties already weighing on investor sentiment. The accelerating conflict developing between Russia and everyone else over Ukraine sovereignty added to geopolitical anxieties as did continuing headline news of global omicron infections. Stimulus plans at home, such as the promised Build Back Better legislation, appeared to be dead on arrival. Politics was once again polarized with midterm elections looming. Global growth forecasts were downgraded. And market watchers were suddenly aware that fiscal and monetary tailwinds were reversing course sooner than expected.
Several factors paved the way to this moment—much of which can be attributed to the uneven recovery following the global pandemic shutdown. Unfortunately, the irregular recovery is a post-pandemic hallmark across countries and markets, fostering mismatches in consumer demands, warehouse inventories, manufacturing, jobs and resources. With supply chains not fully functional and global transportation networks either overloaded or unavailable, shortages and price inflation were inevitable.
One visible example of the economic reboot issue is the computer chip industry, integral to a host of manufacturing and consumer-dependent industries. Although deliveries have improved, a recent U.S. Commerce Department report highlighted continuing shortages. Computer chip inventory shortages now sit at five days of supplies versus the 40 days’ supply that existed before the pandemic, while chip growth demand increased 17% through the pandemic. The issue now is restarting production and delivery from mostly overseas sources while triaging computer chip demand.
As with most economic issues, however, this problem is transitional and will adjust as manufacturers work through supply chain issues. In the interim, this issue also encapsulates the Fed’s conundrum of managing an inflationary backdrop (now at a 40- year high), a feared slowdown in economic growth, rising oil prices and a tight labor market. Now, Fed Chairperson Jerome Powell’s messaging last week of impending rate hikes and the winding down of asset purchases and the Fed’s balance sheet securities has elevated these issues to the forefront.
Transitory or Transitioning
The spike in CPI inflation last month to 7% on a year/year basis—the highest growth increase since 1982—was a somewhat unexpected development. This news reaffirms that consumers were paying higher prices for a broad basket of goods because of the earlier mentioned supply constraints and monetary/fiscal policies, post pandemic demand and labor shortages. Whether this level of inflation (and pricing) is durable is the question investors are asking and the Federal Reserve is hedging.
Certainly, the majority of the inflationary spike is tied to post-pandemic, pent-up demand and constrained supply as witnessed by the run-up in housing prices, building supplies, home furnishings, appliances and autos. Traditionally, these costs will fade as demand pressures decline and inventory rebuilds. Early signals of this phenomenon are likely to be reflected in January’s economic data. As a point of reference though, durable costs rose by almost 17%, or four times the increase, for expenditures on restaurants and personal care, a trend that is not generally sustainable. Increased costs
with staying power in the near term are likely to be labor, rents, commodities and potentially food.
Inflationary issues are not unique to the U.S. either. Last month, inflation rose to a 30-year high of 5.4% in the U.K., while in the European Union, inflation is expected to hit 5%. Rising food costs are becoming a more pronounced issue in Africa as is also the case with higher fuel prices in Europe. In this rising rate environment, central banks overseas are facing the same inflationary issues that the Federal Reserve addressed last week. Inflationary pressures are rising, and monetary policy changes are inevitable. Tightening will vary by country, but global efforts share similar goals of supporting economic growth, jobs, and price stability.
Here at home the Federal Reserve was relatively clear in the messaging last week that rate hikes are coming. Answers to the questions of how rapidly and to what extent will continue to be data dependent. The initial rate increase will probably take effect at the March FOMC meeting, and depending on future jobs and inflation data, may include up to four additional hikes before year-end, all likely in the one-quarter percent range (25 basis points).
Also lined up is a reduction of the nearly $9 trillion in securities held on the Fed’s balance sheet, mostly Treasury and mortgage-backed securities, and the cessation of monthly securities purchases that began early in the pandemic to maintain market liquidity and stability. The end game is to maintain stability in the financial markets, support continued economic growth and bring inflation back to the targeted range of 2%. As we might expect, however, from this point forward, investors will be more fixated on Fed commentary action, corporate earnings, and the market’s transition through a new inflationary environment.
Job Seeker and Homeowner Perspectives
Messaging is mixed for the average household, although the underlying trend has been mostly positive in terms of post-pandemic jobs recovery and a stabilized financial situation. According to Fed data, U.S. household disposable income actually improved during the pandemic while net worth increased approximately $28 trillion since the end of 2019 through the third-quarter of 2021.
The unemployment rate of 3.9% sits at near record lows, and that is also true of continuing unemployment claims. Jobs are plentiful with more openings (10.56 million) than people apparently looking. Unique to the COVID-era, however, is the number of people who have not returned to the job markets, as evidenced by a post-pandemic lower labor participation rate, and the number of people who have left the workforce either to take care of someone with COVID or who are themselves infected by the virus (8.75 million people). Another 3.22 million people are not working out of concerns for catching or spreading the virus.
Although labor statistics will continue to be volatile for the next few months, the outlook does turn positive with the trend in increasing vaccines and boosters. Where the impact becomes more dynamic is in the services industry, expanding as people feel safer in moving out from their comfort zone for dining, entertaining and traveling. The latter trend is becoming more apparent as people continue taking to the airways. Looking at one datapoint, TSA Checkpoint, this past Friday, January 28, 1.63 million travelers were checked through the airport, up 112 percent over last year but still down a bit (-22 percent) from the same time in 2020.
In the housing markets, the flurry of new construction permits, housing starts and new/existing home sales over the past two years has been indicative of the pent-up demand to move out of the parents’ home, to a new location or to somewhere more comfortable for “working from home.” Although fundamentals have been strong, builders have encountered the same supply chain issues that manufacturers have faced. Lumber price spikes, shortages of staff and a demand for housing have resulted in a growing backlog of construction for homes under contract and a longer lead time to build and deliver a home.
While recent news of impending rate hikes has created worries that an aggressive Fed might tip the economic scales towards a recession, some historical data exists to qualm a few of those concerns. Bespoke Research recently noted that housing starts typically peak well in advance of a recession, and with today’s 12 month average at its highest level since April 2007, this data point may give investors one less concern—for now.
Still, the housing industry and homebuyers face a few obstacles that will likely slow down the levels of growth we’ve experienced over the past two years. Issues include increasing home prices, falling housing inventories, and most recently, rising mortgage rates. Positives for the housing industry though include strong consumer balance sheets, available credit, growing household income and still pent-up demand.
One last observation: Consumers, job seekers and households have fared relatively well as the economy has pulled away from the pandemic shutdown. Sentiment has also held up rather well until recently. This month’s University of Michigan consumer sentiment reading trended lower to an index reading of 67.2, the lowest level since November of 2011. While still in “positive” territory, the decline reflects a change in sentiment because of the ongoing delta and omicron variant outlook. Also new this time was a decline in confidence in government economic policies, which fell to its lowest level since 2014.
Last year’s market returns quickly became pages in the history books as the markets repriced their constituent stock holdings following the Fed’s commitment to hike rates to offset inflationary threats. As a result of monetary policy changes, financial assets are generally repriced based on rate exposure, cash flows, earnings growth and growth prospects. The issue, of course, is that investors generally hit the “sell button” before working through the data. These past weeks have been no different. Looking at the broad global indexes and the broad sectors in the S&P, everything appears to have sold off from relatively recent highs. As of this writing, the S&P is wavering in/out of correction territory (10% off its high), and the broad global markets (ex-US) is getting close. However, the brunt of the sell-off (from the highs) was taken by the emerging markets and the US small cap markets (Russell 2000), off 20.75%.
The indiscriminate selling across all market sectors is interesting as well. While some company stocks were excluded, the broader sectors were weighted down by the momentum of larger cap weightings of the index constituents. In the accompanying chart “No Safe Market Sector,” the two sectors that sold off “less” are compared to the two with the most downward momentum. Those sectors that fared the best were two that would be expected to be in a more defensive posture, consumer staples (off 2.5%) and energy (off 4.3%). The two selling off the most quickly fell into correction territory with both the consumer discretionary and communications sectors dropping more than 15%. These sectors were two of the go-to investments at the beginning of the COVID-lockdown. Also worth noting was the correlation between these two sector sell-offs and the timing of the Fed’s announced monetary policy changes.
Although the timing of the broad sell-off was noteworthy, it was more of a long overdue correction rather than necessarily the beginning of a bear market. As noted by BCA Research, at the beginning of 2022, the S&P 500 had risen 61 straight weeks without experiencing a 6% drawdown, the third longest stretch in two decades. There is also comfort in the fact that market multiples are trading at more reasonable levels following the sell-off at 22 times 2022 S&P earnings.
Regardless, the Fed is much more hawkish than a few quarters ago, and that will continue to create ripples with investor outlooks. There will likely be more negative economic news ahead related to omicron, staffing and supply chains, and corporate margin compression with rising interest rates. The good news on the latter front is that most companies took advantage of low interest rates over the past two years, borrowing at fixed lower rates while extending their maturities. Also interesting is that despite higher rates, according to FactSet, analysts are predicting improving margins for the S&P 500 over the next three quarters, with margins at 12.4 percent, 12.7 percent and 13.0 percent over quarters 1, 2 and 3. The expected margin this past quarter was 12 percent.
While there will still be more volatility ahead of the markets, there are positives to keep in mind:
• Markets have been digesting this tightening for months. While there is damage to the broader benchmarks, the sell-off below the surface was more significant last year. Many of the more speculative names were sold off months ago.
• As omicron fades, service sector revenues (earnings) should accelerate and boost earnings for those constituent companies.
• Global markets, while also subject to monetary policy changes, continue to recover, and they will help support U.S. exports through 2022.
• Business capital expenditures are still on track to increase this year which will support manufacturers and suppliers.
• The housing industry is still strong with builders facing a long backlog of presold housing.
• Job growth should remain strong which would ensure future consumption and growth.
• Companies will adjust and adapt to this new monetary environment and continue work towards delivering shareholder value (maximizing revenue and controlling expenses). This is just another chapter in the playbook.
• Finally, this market environment tends to favor companies that have tended to be out of favor over the past few years, especially the more value-oriented, dividend paying, cyclical companies. Companies that were in favor over the past few years, during the early pandemic era, will still be in favor, but the key will likely be valuations based on identifiable earnings and cash flow. A stock-pickers market.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.