Market Commentary - April 2022
“We’re gonna be in the Hudson.”
— Captain Chesley Burnett Sullenberger III, January 15, 2009
No, they didn’t land in their original destination of Charlotte, North Carolina. But if you ask any of the 155 passengers if they were satisfied with their journey, the response would be resoundingly positive. There had not been many good alternatives for U.S. Airways Flight 1549 that afternoon.
Shortly after take-off from New York’s LaGuardia, the Airbus ran into a flock of birds resulting in total engine failure. Cool Captain Sully realized the plane lacked the power to return to any airport and informed the passengers they were heading for a water landing. The rest of the story is the stuff used to make movies.
Captain Sully retired in 2010, but perhaps he’d consider playing the role of hero once more—this time assisting the Federal Reserve as they guide an economy with few landing options.
What is our current location and trajectory? How did we get here and what pathways remain viable?
How will the financial markets respond to pilot maneuvers?
The U.S. economy has been cruising: Q4 of 2021’s real (above inflation) gross domestic product (GDP) was growing at an annual clip of 6.9%. (1) In a report issued this week, the U.S. economy added 431,000 new jobs in March and unemployment, at 3.6%, has completely recovered from the Covid-related collapse. (2)
All positive, right?
When Covid grounded the global economy to stall speed, both Fiscal and Monetary throttles were thrust up to maximum levels. Though effective in regaining flying altitude, the unintended consequence has been exceeding “absolute ceiling”, an aeronautical term meaning, “we can’t maintain this speed.” Demand for both goods and services exceed supply, resulting in inflationary pressure.
The genesis of today’s inflation can be traced to March 22, 2018, when the U.S. imposed $50 billion of trade sanctions on China. As discussed in our October 2021 report, “U.S. importers absorbed more than 90% of additional costs resulting from the 20% U.S. tariff on Chinese goods.” (3) Covid exacerbated the problem by disrupting supply chains and disrupting an economy highly dependent on global trade. Despite these problems, the long-term projection for inflation in the fall of 2021 was a benign 2.38%. (4)
Today, those same metrics imply inflation going forward at 2.79% (5). In the spring of 2020 with the world in lockdown, inflation expectations bottomed at .50%, causing the Fed to publicly proclaim a target of 2% inflation. Why are we now closer to 3.0%?
First, the Fed learns from past mistakes. After climbing out of the Great Depression in the early 1930s, the economy began to recover by mid-decade, and seemed to have “normalized” by 1936. In response, the Fed began restricting the money supply. Unfortunately, between May of 1937 and June of 1938, the U.S. economy suffered the third worst downturn of the 20th century. (6) GDP fell by 10% and unemployment reached 20%. Federal Reserve Chairman, Jerome Powell, has no appetite for a rerun of that show while under his watch. Better to err on the side of growth and keep Americans employed.
Second, the unexpected exogenous shock (“birds in the engine” moment) came when Russia invaded Ukraine. Consider the following price changes in oil and wheat, both produced by Ukraine and Russia but not necessarily available in the markets. (7)
In October Neel Kashkari, President of the Federal Reserve Bank of Minneapolis shared his view that inflation was “transitory” and that he didn’t expect to see interest rates rise until 2024. (8) Now, the Fed has no choice but to act.
During the official Fed meeting in March, Chairman Powell reiterated his determination to stopping inflation and announced his “approach.” The Fed plans to raise interest rates at each of the next six meetings and is willing to move in .50% increments instead of the previously executed .25%. He added his intention to reduce the Fed balance sheet starting in May. (9)
The bond market: Bond market participants expect the Federal Funds Rate to rise to 2.8% by 2023. (10) Though certainly elevated from the 0% target that has been in place since Covid-19, this rate is still low by historical standards. (11) Of greater concern is the steepness of the ascent necessary to get rates up that high in only nine months.
The stock market: The S&P 500 dropped 12.26% to start 2022 before bottoming on March 8. Despite the volatility, the stock market has been mostly positive for the past three weeks. Some attribution goes to the strong energy sector. However, one could reasonably interpret the good performance to an underlying faith that the Fed will be willing to ease up once the economy demonstrates sufficient slowing.
Can the Fed pull off a “water landing”?
The optimists lean on the following:
- Supply Chain Constraints: Though not the exclusive cause of price hikes, supply chain played a significant role and should ease with the cessation of Covid-related plant closures and employees returning to work.
- Jobs: Unemployment is down to 3.6%, near 60-year lows. (12)
- Insulation: Europe will take the brunt of the food and energy crunch emanating from the Ukraine/Russia conflict. (13)
- Forecasts: The Atlanta Fed compiles economic data from leading forecasters and estimates 1.5% growth in the next quarter. (14) Morgan Stanley (4.0%), Goldman Sachs (1.75%), and Yardeni Research (2.0%) all see continued GDP growth for 2022. (15)
- Consumer Confidence: Despite concerns about inflation and Ukraine, consumer confidence rose in the latest poll. (16)
- Manufacturing Activity: The Institute for Supply Management survey on manufacturing came in at 57.1% for March. Though lower than February, any reading above 50% signals growth. (17)
The gloomier views stem from:
- Conflict in Ukraine could drag on, keeping commodity prices elevated.
- Covid-19 related supply chain challenges will not improve while China enforces lockdowns.
- Rising costs for food, gas, and rent could eventually reduce consumer spending on other discretionary expenses.
- Demise of Globalization: Larry Fink, CEO of BlackRock ($10 trillion under management), recently wrote, “Russia’s invasion of Ukraine has ended globalization as we know it.” (18)
- The economics department from Princeton University recently presented a historical view of Fed tightening cycles. (19)
- It concludes “seven of the eleven episodes were arguably pretty soft.”
- For the periods starting in 1972, 1977, and 1980, there was no intention of making it soft.
- “So, soft landings can’t be all that hard to achieve.”
- Crisis Events have been identified (50 since 1900) and studied by Ned Davis, the reputable market historian. He found “remarkable symmetry” in market action with immediate market drops followed by gains in the following 3 weeks, 9 weeks, and 18 weeks. (20)
Financial markets feast on certainty but, there’s not much available. The economy isn’t the only fuzzy issue. Geopolitics, inflation, consumer behavior, and earnings remain opaque. Despite these challenges, the S&P 500 (4549; 4/5) trades for almost 20 times projected earnings ($233). (21) As you can see in chart below, the 20X seen at the far right of the graph (red line) has only been exceeded by a brief period in the late 1990s, going back to 1978. (22)
WCF has taken two approaches toward this market. First, we have modestly reduced our cyclical exposure by selling a few positions that depend on a strong economy. Second, we have moved toward defensive positions in the areas of food and storage facilities, typically less sensitive to the economy with dividend yields that are higher than the overall market.
We will soon add exposure to multi-family housing investments, which appear to be doing well within the rising millennial population as well as within the overall market of increasing housing prices and mortgage rates.
When pilots lose visibility, they rely on Visual Flight Rules (VFR), rules that guide a pilot through difficult conditions. We may not have a clear view of where the economy or the war in Ukraine are heading, but we do have a set of rules that should help to maintain your flight plan.
- Bureau of Economic Analysis; March 31, 2022
- Bureau of Labor Statistics; April 1, 2022
- “U.S. companies are bearing the brunt of Trump’s China tariffs, say Moody’s.” CNBC; May 18, 2021
- FRED; St. Louis Federal Reserve Bank; November 4, 2021
- FRED; St. Louis Federal Reserve Bank; April 3, 2022
- “Recession of 1937–38,” FederalReserveHistory.org
- “Fed’s Kashkari Is Comfortable with Plans to Taper Bond Buying Soon.” Wall St. Journal; October 1, 2021
- “Powell says ‘inflation is much too high’ and the Fed will take ‘necessary steps’ to address.” CNBC; March 21, 2022
- “Fed Lifts Rates a Quarter Point and Signals More Hikes to Come.” Bloomberg; March 16, 2022
- FRED; St. Louis Federal Reserve Bank
- Bureau of Labor Statistics; April 1, 2022
- “Surprise! The U.S. Is Still Energy Independent.” Forbes; March 8, 2022
- GDPNow; Federal Reserve Bank of Atlanta; April 1, 2022
- “Rate Hikes Raise the Odds of a Downturn.” Barron’s; March 31, 2022
- “U.S. consumer confidence rises for first time in 2022, but inflation and Ukraine still big worries”. Market Watch; March 29, 2022
- “U.S. factory activity stumbles in March to lowest level in 18 months, ISM survey shows.” Market Watch; April 1, 2022
- “BlackRock CEO Larry Fink Says Russia-Ukraine War Is Upending World Order And Will End Globalization.” Forbes; March 24, 2022
- Landings Hard and Soft: The Fed, 1965-2020; Alan Blinder; February 11, 2022
- “‘Every Market Is Oversold’: Wall Street Bulls on Ukraine Crisis.” Bloomberg; February 22, 2022
- Earnings Insight; FactSet; April 1, 2022
- “S & P 500 Trailing PE Ratios.” Yardeni Research, Inc.; April 5, 2022