Published August 19, 2022
It has been quite a long time since we have seen such disparity in the narratives flowing down Wall Street. How long and hard the Fed will tighten rates is one source of contention. But it’s not the biggest. That would belong to where corporate earnings are headed, which is sort of a Street barometer for whether or not the economy falls into a recession (how deep that recession is a third dimension discussion floating around also). Here are two examples of the competing narratives investors can choose from right now.
First, the bullish view from JP Morgan’s market strategist Marco Kolanovic: “Given our core view that here will be no global recession and that inflation will ease, we think investors are significantly underexposed to stocks,” Kolanovic wrote. “It takes quite awhile for rate hikes to work through the system. With just one month before very important US elections, we believe it would be a mistake for the Fed to increase risk of a hawkish policy error and endanger market stability.” So, the Fed is less aggressive, the economy holds up, and investors will have no choice but to embrace stocks more fully.
Then, there are any number of bullish calls from various seasonal and other technical factors. Here is one of those – the midterm year of the Presidential cycle is always tough. But it finishes strong. The blue line below shows the composite of those first and second-year cycles. The red line shows where we are today. Lots of upside ahead?
But the bears also have plenty to work with. First off, just the sour performance of the stock market so far in 2022. Many say the worst is still ahead. Their reasoning is that corporate earnings have not yet felt the effects of the economic slowdown. They argue that the reports coming in October will display more strain from a slowing economy. Here is one of those views, from Invesco’s head of tactical asset allocation: “Broadly speaking, equity and credit markets have not discounted the additional underperformance due to lower earnings growth to be expected in a recessionary scenario.” Invesco tells investors to be cautious and prefer bonds over stocks until this negative cycle plays out.
Another feather in the bear’s cap, the inverted yield curve. There is much discussion about which yield curve matters most (e.g. 2 year versus 10 year? 3 month compared to 10 year?). Schwab discards the question by taking all the yield curves and combining them into a cumulative measure. We can easily see that the spike in yield curves inverting (shown by spiking blue lines) leads to recession (shown by the gray bars). Right now, the blue line on the far right has reached 50% of yield curves having inverted. That’s not quite the 70%+ of prior recessions. But we are fast approaching that point unless something dramatically changes in the Fed’s short-term playbook.
[As a quick note, inverted yield curves mean short-term interest rates are higher than long-term rates. The Federal Reserve has much more influence over short-term rates with long-term rates being more driven by the market’s expectations for long-term economic growth and inflation. An inverted yield curve indicates that the Fed is pushing up short-term interest rates to slow down the economy, AND that the market believes it will succeed in driving economic growth and/or inflation down (hence, lower rates out in time).]
Finally, we end our survey with perhaps the most perplexing of economic inputs – the labor market. There have been many high-profile layoffs in the high-flying tech/consumer area. But that hasn’t moved the needle on employment, which remains extremely tight. The tight labor market pushes up wages which supports the idea that inflation will remain higher than the Fed would like. But tight labor markets also suggest a strong consumer. And the consumer drives 70% of the U.S. economy. How can we have a recession when almost everyone has a job, wages at those jobs are rising, leading consumer spending to remain robust?
The stock rally continued Monday with a broad-based though modest +0.4% move higher. Stocks have been rallying on the idea that inflation has peaked and Federal Reserve interest rate hikes will ease. Monday’s move higher came despite a report that China’s economy slowed enough for their central bank to cut interest rates in an effort to stimulate demand. This pushed down oil prices but had little effect elsewhere in the market. Tuesday brought better than expected reports from a couple of big retailers. Shares of Home Depot and Walmart pushed upward after their reports to help keep the market moving forward. The broad market response was a tepid +0.2% lift, however. Stocks gave back their gains for the week in Wednesday’s session as minutes from the Fed’s most recent meeting offered little new information and stocks looked to be out of fresh buyers. Stocks held flat Thursday with home sales recording their sixth straight decline after their sharp 2021 climb. A shot across the bow of the bulls Friday when Fed member Bullard expressed support for a +0.75% September rate hike. Market participants have been cozying up to the view of a lesser +0.5% September Fed move. Growth stocks slipped -2% as interest rates perked up on the Bullard comment.
A fifth straight weekly gain was not to be as stocks hit their 200-day moving average line and fell back. The S&P 500 (SPY) dipped -1.16% while the Nasdaq 100 (QQQ) fell -2.28%. Smallcaps (IWM) suffered a -2.85% downdraft.
Warm wishes and until next week.