Here are our latest thoughts and observations on what is driving market angst – and what we are watching for as we move into Big Tech earnings week and beyond.
Market Struggling for Clarity
The 4200ish level on the S&P 500® is being carefully watched by everyone. If it sinks lower, then market technicians are calling for a pull back to the 3500 area. That would be another 15% decline from here – and a total drawdown of 25% from peak to trough. We are not technicians, but we get it. A clean break of 4200 is – well, not good.
S&P 500® Price Level
(12/31/20 - 4/24/22)
Big Earnings Week for Big Tech
So why is the week of April 25 so important? Earnings. If anyone or anything is going to save the day here, it’s going to be Big Cap Tech. The Generals. And to give the specifics:
- Tuesday after the bell: Google and Microsoft.
- Wednesday after the bell: Facebook – or whatever you call them now.
- Thursday after the bell: Apple and Amazon.
Yes, there are plenty of others reporting this week, but these are the ones everyone will be looking at. If the market is going to take out 4200, we think it’s because these guys in aggregate whiff.
Earnings reports thus far in 2022 have been pretty good. So what’s the problem? Tepid to bearish guidance about sales prospects has fueled concerns. Remember that consumer consumption is 70% of the US economy. So, as companies tend to be in the business of managing expectations, it becomes easier to imagine that they may not be giving great outlooks. China’s zero Covid policy. Russia/Ukraine. Commodity prices. Labor market issues. Increasing wages. The Fed. Do you think they want to step out on a limb and sound all warm and fuzzy about the next 12 months? Companies have limited visibility as they battle the post-Covid growth hangover and price-to-earnings compression on stimulus withdrawal.
The funny thing is, we could very well see the stock market price in a recession but never get one. A stock market recession without an earnings recession. Quite ironic. So it all comes down to this: The Big Cap Tech names can save the day or exacerbate the selling.
Let’s now tackle the economic side of this market backdrop. Why is the market so spooked? Who knows? But it seems obvious that inflation and Fed rate hike fears are key drivers. Our take on this – and what we believe makes a huge difference – is the path versus destination in terms of getting us there. Yes, the ultimate destination is for the Fed to get inflation back to 2%. But how we get there matters. And this creates different outcomes for the stock market.
Fear of Fed Missteps
To us, the market is struggling to figure out what the terminal fed funds rate will be. This is the rate where everyone is happy. The economy is still growing, but inflation is in check. It’s an arbitrary level because no one knows what that rate really is. It’s all about trial and error to figure out what that clearing level will be. And because it’s trial and error, the market has a bias to assume that the Fed will screw it up and crack the economy – and thus the markets.
But if we look at the market’s perception of what that terminal rate might be, we can look to the 5-year Overnight Index Swap (OIS) rate five years from today (chart below). The OIS rate is simply the rate one charges to swap payments between fixed and floating rate coupons. It tends to follow the market’s expectations for Fed moves, so it is a good proxy for rate expectations. We go out five years to assume that by then, we are at that terminal rate and everything is good. You can see below that the 5Y5Y OIS rate has spiked recently: 3/4/22: 1.62%, 4/4/22: 1.98%, 4/24/22: 2.57%. The market is repricing that terminal Fed rate – and the spikes are telling us that it is still struggling to digest what the Fed needs to do.
5Yr 5Yr OIS Swap
(4/24/17 - 4/24/22)
Inflation Remains a Hot Concern
Inflation expectations are also playing a big part in the repricing. Check out inflation expectations – 5-year inflation 5 years from now, in the chart below. It had been in a range for some time, which gave us comfort in calling for the markets to be able to digest the Fed interest rate hike backdrop. We got a spike higher, denoted by the red box. But that was associated with the Russia/Ukraine conflict. Did that change things? Possibly. Maybe we underappreciated the long-term ramifications of the war. But more troubling – even after the bounce higher in inflation expectations resulting from the conflict, that move continued to drift higher – and pulling with it higher, the Fed terminal rate.
5 Year Inflation 5 Years Forward
(4/27/20 - 4/24/22)
US economic data continues to surprise to the upside, as well. This certainly isn’t helping to ease inflation worries in the US. In fact, as of its April 22, 2022 reading, the Citi US Economic Surprise Index, which looks at actual growth prints vs. expectations, came in better than expected.
So, the market doesn’t know what the terminal rate should be. Inflation expectations are drifting higher. The economy is still strong. And the Fed & Co. are all talking tough. It’s not surprising the markets are struggling in here. Is all lost on the inflation front? Here are a few more items to consider.
Fed’s Forward Guidance at Work
The Fed has hiked once so far in 2022, by 25 basis points. But their forward guidance is hard at work. Take note in the table below.
|in %||10/22/2021||4/22/2022||Delta||% Change|
|Auto Loan Rate||3.68||4.23||0.55||15%|
|30 Year Mortgage||3.19||5.29||2.1||66%|
|5/1 ARM Mortgage||2.69||3.52||0.83||31%|
|Credit Card Rate||17.13||16.17||-0.96||-6%|
Rates on items tied to that forward guidance are already moving up aggressively. This should begin to bite. Let’s compound things. Is the bullwhip effect beginning to kick in? Have we built an inventory glut from overproduction and overordering to make sure that companies have what they need?
Excess Inventory Could Cool Inflation
Manufacturing, wholesale, and retail inventories excluding autos are all well above pre-Covid trends. Excess inventory is not inflationary. And when consumption shifts in earnest from goods to services as Covid restrictions are lifted, then we believe this trend will accelerate. We might just now be seeing the tip of the iceberg here.
Let’s look to the Logistics Manager’s Survey for data – think of this as a survey covering transportation, warehousing, and inventory across all segments of the US economy. Its March 2022 report states that the first three months of 2022 have been marked by high levels of inventory, and insufficient capacity to deal with it. Again, excess inventory is not inflationary.
Another Force to Keep in Mind: China
With domestic demand suffering under the load of the Chinese government’s adherence to zero Covid, they have in essence supported growth by importing demand via robust global goods consumption. What happens when that goods consumption starts to slow as consumers buy less stuff and take more trips? Support growth at all costs. Slash prices and keep the export engine roaring. Exporting deflation.
- If the Fed wants to engineer a soft landing, they will have to prevent the unemployment rate from rising aggressively. To do that means that they will need to let inflation run above their target for longer. Flexible Average Inflation Targeting at its best.
- The destination is greater than the path, here. As long as the Fed continues to guide inflation towards its 2% target and continues to make tangible progress on that, they will be happy. And in doing so, unemployment remains in check… but inflation will likely take longer to reach that 2% goal.
- The issue right now is getting the markets to believe that this can be engineered. And this is where the markets are struggling. Inflation break-evens are moving higher again and thus that terminal Fed rate is in flux. And this means additional hand-wringing and consternation.
- Earnings will be the key as to whether the markets hold in here or break lower. If large-cap tech delivers good earnings reports in April, then we might buy some time. If not, we could begin pricing in a stock market recession well before an economic recession is solidified.
Plenty can happen between now and then. We are not in that recession camp. Not yet anyway. But markets want to have it and they want to have it now. We’ll let the data dictate the journey. Buckle up. We should be in for quite a ride this week.
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