Markets are up—but should they be?
The Fed is starting to apply pressure, but consumer spending hasn’t slowed (yet).
Our Top Market Takeaways for March 25, 2022.
The equity market keeps rallying, and nobody really knows why. Heading into Friday trading, the S&P 500 has tacked on another +1.3% to its torrid rally from last week. The Nasdaq 100 added another +2.5%, while Europe is about flat.
This is despite the most hawkish version of Jerome Powell yet (see his economic outlook speech from Monday, when he suggested the Federal Reserve would not hesitate to move monetary policy to territory that would actively slow the economy), bond yields across the curve soaring (2-year U.S. Treasury yields are almost 20 basis points (bps) higher over this week, and 30-year Treasuries are near cycle highs), continued volatility in energy markets (WTI crude is back above $110 per barrel), and no clarity in Russia’s horrific war against Ukraine.
Here are some possible reasons why the S&P 500 is up almost 8% over the last eight trading days.
- Investors had just gotten too negative. Worrying about nuclear war, oil rationing and impending recession all at once results in lower equity prices. The relative lack of any material new news is better at the margin.
- The equity market is calling the Fed’s bluff. The stock market doesn’t think the Fed will actually go through with its plan to raise the policy rate to 2.75% by the end of 2023.
- The equity market actually had something worse from the Fed in mind. There is no way of actually proving this, but it is notable that ARKK (here, a proxy for a basket of potentially high-growth but speculative companies – one of the cohorts most sensitive to tighter policy) is up 30% since last week’s lows, while the Nasdaq 100 (likewise theoretically hurt by higher interest rates) is up almost 13%.
But for long-term investors, the reasons for the rally over the last few days are less important than the perplexing set of headwinds and tailwinds for the U.S. economy and markets that are clouding the medium-term outlook.
Coming in to the year, it seemed to us as if the tailwinds had a clear advantage, but the Fed’s plans for an aggressive tightening cycle have evened up the match.
To help assess where we might be heading, we broke the U.S. economy into four cohorts: the Fed, Wall Street, Main Street and the C-Suite.
The Fed, Wall Street, Main Street and the C-Suite
 The Fed is embarking on an aggressive rate hiking cycle that has the stated goal of “Restoring Price Stability” (i.e., getting inflation down).
At this point, markets are priced for another 175-200 bps of rate hikes this year, which means that we are likely in for a 50 bps rate hike or two at some point. This hiking cycle will resemble the 1994 experience (when the Fed raised rates by 250 bps in a calendar year, with two 50 bps moves and one 75 bps monster hike in November) much more closely than the relatively gentle cycle of the late 2010s.
 Wall Street is convinced that something in the economy is bound to break. Between higher rates, higher inflation and higher gas prices (the thinking goes), there is no way the consumer will be able to keep the pace.
By many frameworks, rates are already at levels that should be cooling the economy. Mortgages are back above 4.5%, where they were in 2019 when the housing market cracked. The slowdown is likely to show up in housing first.
Most of the U.S. Treasury yield curve is flat or even inverted, and the money markets are already pricing in interest rate cuts in late 2023. This suggests that bond managers don’t think the economy can tolerate the hiking cycle the Fed has in mind.
Equity managers are holding their highest allocations to cash since April 2020, and close to 70% of managers expect weaker economic growth going forward, the most since October 2008.
 Main Street is frustrated by the economy, but it hasn’t noticeably changed its behavior. At least not yet. Consumer sentiment surveys have been at recessionary levels for months, but card-spending data and retail sales are still robust.
A record low number of survey respondents think now is a good time to buy a house, but they are still consistently paying above the asking price for homes. While mortgage rates should be pinching the housing market, real-time demand indicators are surprisingly strong. However, given the rise in mortgage rates, new mortgage applications and home sales data should soften going forward.
The only thing record-high gas prices are good for is local news correspondents who need segment ideas, but Americans are still hitting the road. Data from gas savings app GasBuddy suggests that demand for gasoline actually hit a pandemic-era high in the same week that gas prices did. It doesn’t seem like we are at a point where gas prices are causing demand destruction. At least not yet.
Finally, pent-up demand still does seem to exist for travel and services that were disrupted by COVID-19. Look no further than Fabulous Las Vegas. Card spending on the strip is 35%–40% above 2019 levels. Casino operators from MGM to Caesars to Wynn have been impressed with recent demand, and are expecting a continued travel boom through the spring and into the summer.
 The C-Suite seems almost apologetic for how good its results have been. Next 12-month earnings expectations for the S&P 500 have actually climbed this year as consumer and corporate demand has come through. While the C-Suite seems wary of a consumer slowdown coming, it hasn’t seen it. At least not yet.
Nike, Lennar (a homebuilder), Home Depot and Disney have all recently offered upbeat forward-looking commentary. While corporate earnings may be the last place a consumer slowdown may show up, it is still notable that most management teams seem pleasantly surprised by the durability of demand.
When uncertainty is high, simplify
The Fed is going to antagonize markets this year, and Wall Street is convinced the economy is going to slow. However, consumption and corporate confidence is still high. Investors are uncertain about whether the headwinds or tailwinds will prevail, and the recent volatility is indicative of the controversy.
Here are the simple descriptions of where we stand, and what we are doing about it.
The Fed: Expect an aggressive hiking cycle until inflation rolls over. The most likely outcome for the economy is a “soft-ish” landing, but risks have risen.
- Investment implication: We are refocusing on core fixed income, especially now that a historic selloff in municipal bonds is providing an entry point.
Wall Street: It’s hard not to see a volatile, range-bound equity market in the near term, but some pockets could be set to outperform.
- Investment implication: The megatrend of digital transformation is still gaining momentum, and valuations have corrected materially. We think technology stocks seem attractive.
Main Street: Housing and durable goods consumption are likely to cool, but services spending could be more resilient.
- Investment implication: If growth does slow down, the consumer will likely be the cause. We are watching the housing market, services sector spending, and credit card utilization for signs of consumer stress.
The C-Suite: Higher-quality firms with secular drivers and strong management teams should outperform.
- Investment implication: We think high-quality businesses trading at a discount to the market could provide a haven while uncertainty prevails.
Above all, creating a plan and sticking with it are the best ways for investors to maintain control and confidence when the range of possible outcomes is wide.
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