The stock market recovery that began on March 15th has stalled out as comments by Fed Governor Lael Brainard on Monday scared investors in terms of the amount of Quantitative Tightening that might occur later this year and into next year. The stock rally had as its narrative underpinning the idea that while the Fed might say they were going to hike rates seven times or more, economic and market weakness would never permit that. Stock investors are uncomfortable with interest rate hikes and the Fed contracting liquidity at the same time. The analog is the fourth quarter of 2018. When the Fed actually began withdrawing liquidity, stocks dropped about 8% (9/20/18 to 10/25/18). The market then rallied for two weeks for the same reasons it has recently – stocks were technically oversold, the economy continued to grow, and though the yield curve had modestly inverted, the timing of weakness was uncertain. A strong-ish unemployment report in early December 2018 confirmed the Fed was right to tighten, and stocks began to fall in earnest. The employment report we received last Friday (4/1/22) confirmed to the Fed that a 50 basis point move at the next meeting (May 4th) was probably warranted. Brainard’s speech was the catalyst for short term interest rates to soar (since she implied that the Fed was going to be rapidly moving from modest purchases of short-term bonds to fairly heavy sales). This is obviously not good news for any security whose valuation depends on lower interest rates, including growth stocks and homebuilders. The concern now, of course, is about a rapid stock sell-off like the one we got in December of 2018 as stocks protested Fed policy. And lest you conclude that the Fed will capitulate this Spring as it did back then, I would point out that reported inflation was around 2% at that time versus upwards of 7% today. The Fed knows it screwed up last time. It won’t want to make that mistake again.
Commodities continue to outperform both stocks and bonds. The War in Ukraine is a major part of this as it has lit a fire, so to speak, under both energy and agricultural prices. The problem is that even before the invasion there were structural issues – underinvestment, transportation snarls, etc. – affecting commodity prices. Commodity-driven inflation is going to moderate, even if the war is swiftly concluded, but it is not going away for the foreseeable future. The energy and materials sectors may be outperformers for a considerable period of time. Note that commodities are up 27% year to date, yet gold is up less than 5% and bitcoin is negative. This suggests that the commodity surge is not about the general level of inflation; it is about demand exceeding supply and supply not being either able or willing to fill that gap.
It’s probably an oversimplification to say that value is winning and growth is losing this year. 2022’s winning sectors tend to have lower price-earnings ratios because they are cyclical (energy, materials, etc.), but not all low P/E stocks are winners (financials and industrials are single-digit down this year). The vast majority of high P/E stocks are losers, especially technology, biotech, financial tech, and consumer discretionary). Cybersecurity is the only high P/E subsector that is beating the market right now, though there are many consumer staples companies like Procter and Gamble that have high P/E ratios and are outperforming.
Most bond managers that I’ve talked to recently expect interest rates to peak, and soon, especially at the long end (10 to 30 years). They believe the economy cannot withstand rates much higher than where they are now for very long, and once it is more broadly felt that the economy is headed for a rough landing (May or June?), long bonds will be an exciting capital gain opportunity. Michael Collins of PGIM said this morning that he expected the 10-year bond to fall back below 1.50% in the next easing cycle. This is regardless of where inflation is (though it should be noted that he expects it to fall back to the 2-3% level). According to Schwab’s Jeffrey Kleintop (as reported by Lyn Alden), only 17% of the yield curve have inverted (there are many, many yield curves). Historically, 50% or more of the yield curves inverting has signified recession.
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