Wentz Weekly Insights
Stocks Turn Defensive On Expectation of Faster Moves By the Fed
Bonds and equities sold off again last week as yields rose across the curve, with most of the selling occurring Thursday and Friday. The yield on the 10-year Treasury ended the week at 2.91% after nearly reaching 3.0%, for the highest level since 2018. The energy sector, a clear winner so far in 2022, was down for the week as crude oil fell 5%, while defensive sectors like consumer staples were positive.
The catalyst for the move lower was from several speeches and remarks from key Fed members that suggested an even faster increase in rates and tightening in monetary policy. It was just the December meeting that the consensus of the Federal Open Market Committee (FOMC) was one rate increase in 2022. Fast forward three months later and the latest FOMC statement suggest the consensus sees 7 increases, ending the year with a federal funds rate of 2.0%. However, the most recent comments suggest rates could go above 3.0% by year end with several 50 basis point (one basis point equals one hundredth of a percent), and the possibility of 75 basis point increases.
This highlights the Fed’s urgency of getting inflation down. During his opening remarks at the IMF economic forum on Thursday, Federal Reserve Chairman Jerome Powell, who shares the consensus view of the FOMC, said the U.S. economy is strong, the labor market is extremely tight, and the goal is for a soft landing – or getting inflation down without causing a recession. Powell shared “many” FOMC members thought one or more 50 basis point increase in rates was necessary this year, while all but guaranteeing a 50 basis point increase at its next meeting next week. Then came comments from St. Louis Fed President James Bullard who said he wouldn’t rule out a 75 basis point increase, 2 weeks after speaking on how the Fed is behind the curve.
Investors may have also noticed “real” yields on the 10-year Treasury moved positive for the first time in two years, up from minus 1% last month, reflecting a more restrictive stance. The real rate is the nominal rate (what we see) plus the expected rate of inflation over the investments life.
Another concern to keep an eye on is the Covid outbreak in China and its draconian measures taken to control it. China is a massive manufacturer and exporter of goods, and any additional shutdown has the ability to make the already tight supply chains even worse. The impact could be felt through slower economic growth and higher inflation, the two main concerns in the market today.
This week though, investors will re-focus on earnings as the Fed enters its quiet period before the May 3-4 meeting next week. It will be the busiest week of earnings reports for the first quarter reporting season. Almost 40% of S&P 500 companies are set to report, including the big five – Alphabet (Google), Amazon, Apple, Microsoft, and Meta (Facebook). We reiterate, guidance will be key as companies readjust to higher prices and face the dilemma of raising prices by passing higher input costs onto the consumer, or having higher prices cut into profit margins with lower earnings. We prefer to stay more defensive in the environment, and maintain our overweight to defensive, value, income producing investments.
Week in Review:
US stocks opened the week Monday trading in a narrow range and bouncing between positive and negative territory all day, before ultimately settling lower. There were a lack of headlines as investors prepare for a wave of earnings through the week. A speech by St. Louis Fed President James Bullard indicated he would be willing to do a 75 basis point rate increase in the May meeting while saying the Fed funds rate should be 3.5% by year end, up from a speech he made a month ago when he called for rates of 3.0% by year end. Energy was the clear outperformer on the day as oil moved higher while the S&P 500 closed down just 0.02%.
The report on housing starts and new permits released Tuesday morning rose to the highest level since 2006. Bond yields moved higher again with the 10-year Treasury approaching the 3.0% level, despite remarks from Atlanta Fed President Bostic that the Fed needs to be careful on not being too aggressive to slow growth. However, stocks were able to gain momentum and move higher. Energy was a clear laggard after crude oil fell over 5% after the IMF cut its global economic growth forecast. Travel related stocks performed well after a Florida judge ruled the mask mandate on public transportation was unlawful. The S&P 500 gained 1.61% while the NASDAQ was up 2.15%. In global news, the People’s Bank of China made no changes to rates despite the expectation that it would cut rates, while Russia increases its attacks in Eastern Ukraine and gives a new ultimatum for the surrender of Mariupol.
The highlight going into Wednesday’s trading was a disappointing earnings report from Netflix that showed the first quarterly subscriber loss in 10 years (see details below). Existing home sales fell 3% in February to an annualized pace of 5.77 million units, but supply remains an issue with less than one million homes on the market in March. Netflix’s results set the tone for growth stocks as well as covid beneficiary stocks like those that benefited from work-from-home, which were down on the day, while value performed better. The Dow gained 0.71%, lifted by IBM after its earnings, while the NASDAQ was down 1.22%, dragged down by growth names.
Markets opened firmly in the green Thursday thanks to solid results from Tesla, United Airlines, Dow, and AT&T, among others. Immediately after the open though, stocks moved in a straight line down. After being up by 1.2% in early morning, stocks experienced a dramatic reversal and closed down 1.48%. The reversal was due to a busy day of Fed speak. The most notable remarks were from Chairman Powell who said getting inflation down is “absolutely essential,” while saying a 50 basis point increase in rates is on the table for May’s meeting and “many” FOMC members thought one or more 50 basis point increases were necessary this year. Market is beginning to price in an even higher 75 basis point increase. Fed members’ comments are important as they give their opinions, but the Chairman’s comments are most important because they reflect the view of the FOMC as a whole. Bonds sold off, sending yields higher with the 10-year Treasury approaching the 3% level.
Thursday’s momentum to the downside continued into Friday. While talks continued to be around a new expectation of even faster rate increases, the real yield on the 10-year Treasury – the real yield on the Treasury inflation-protected security minus the yield on the Treasury – moved into positive territory. This reflects a change in markets that will actually start to restrict economic activity, as noted by Barron’s Randall W. Forsyth. Selling was widespread with the S&P 500 having all but 15 companies finishing in the red while the Dow, down almost 1,000 points, had its worst day since 2020. For the week, crude oil fell 4.5%, the 10-year Treasury note yield rose from 2.83% to 2.90%, and major U.S. indices finished as follows: Dow -1.86%, S&P 500 -2.75%, Russell 2000 -3.21%, NASDAQ -3.83%.
Recent Economic Data
- Construction started on (an annualized pace of) 1.792 million homes in March, the highest pace of new home starts since 2006. This is 0.3% above February’s pace, 3.9% above the pace from a year ago, and also above the 1.750 million annualized expected. The number of permits authorized to start construction on a new home in March rose to an annual rate of 1.873 million, the fourth highest since 2006, 0.4% above February’s pace and 6.7% above the pace from a year ago.
- Sales of existing homes fell 2.7% in March to a seasonally adjusted annualized pace of 5.77 million units, down 2.7% from February and down 4.5% from a year ago. Supply of homes remains a major problem – at the end of March there were just 950,000 existing homes for sale, a 10% drop from last year, and at the current sales pace is just 2.0 month supply, remaining near the lowest levels ever. This lack of supply is keeping upward pressure on prices despite the rising mortgage rates. The median price of a home sold in March was $375,300, up 15% from a year prior. Houses are not up for sale long – 87% of homes sold were on the market for less than a month. Sales pace in March seems unaffected so far by the rise in rates (it may lag, rates were still mid-4% range at end of March), however, a note from a realtors survey shows buyer traffic so far in April is down 19% from a year ago.
- The Philly Fed’s manufacturing index was 17.6 in April, near expectations and indicating manufacturing activity continued to expand at a solid pace, but slowing from 27.4 in March. The surveys response on new orders and shipments declined from March, but remain strong, while employment and prices expanded yet again, remaining very elevated. Importantly, firms continue to expect growth over the next six months, however with record high prices.
- The Federal Reserve’s Beige Book, which gives a summary of economic conditions throughout the 12 Federal Reserve districts, indicated the economy remained strong while saying inflation may not have peaked yet. It said inflationary pressure remain strong as businesses continue to pass increased input costs on to consumers, especially in manufacturing where wages and transportation costs are most noticed. Covid lockdowns in China were cited as a risk, while increased commodity prices due to the Russia invasion of Ukraine was noted as another reason for higher prices. Regarding the labor market, firms were noted reporting significant job turnover as employees look for higher wages, which remain strong.
- The number of newly filed jobless claims was 184,000 for the week ended April 16, down 2,000 from the prior week, with the four-week average at 177,250. Continuing claims was 1.417 million, down 58k from the prior week, for the lowest level since 1970 when the labor force was half the size it is now. The four-week average for continuing claims was 1,482 million, also the lowest level since 1970.
- Netflix reported mixed first quarter results while saying it lost a net 200,000 subscribers versus the expected gain of 2.5 million, for its first loss in 10 years. It said the subscriber miss was due to competition ramping up, macro factors such as inflation and Russia, and password sharing. It estimates out of its 222 million paying households, 100 million are sharing accounts. In an unexpected change in strategy, the company said it is exploring ways to add lower-priced, ad-supported tiers that would be phased in over several years. Shares fell 35.12% after its results were released.
- Oil and gas equipment and service provider Halliburton reported first quarter results that beat expectations. But the highlights came from executive’s commentary. The company spoke on the multi-year upcycle it currently sees, in addition to pricing improvements, strong consumer demand with “significant tightness” across the market, and a sold-out equipment.
- CNN+, the paid streaming service of CNN, owned by Warner Bros Discovery which just formed after being spun off from AT&T, said it is ending its service after just one month of launching. The news comes several days after the company said it would cut millions in spending on the service. Reports say just 10,000 people signed up since its launch.
- The International Monetary Fund updated it global growth forecast, now expecting growth to be 3.6% in 2022 and 2023, down from 4.4% for 2022 and 3.8% for 2023. The downside forecast is due to the war in Ukraine, added inflation pressures, including from fuel and food, which it says will hit the low-income individuals, families, and countries the hardest. In addition, it expects inflation in 2022 to be 5.7% in advanced economies and 8.7% in developing or emerging economies, up by 1.8% and 2.8%, respectively, from its January forecasts.
- Mid-week, Russia was planning a major offensive in the Southeastern, industrialized city of Mariupol, but Thursday Putin claimed the city was “securely blocked” and ordered Russian troops to not storm the city, saying Russia control of the city was a success. Russia also said it successfully tested its new intercontinental ballistic missile, which Putin said would make the West “think twice” about aggressive actions against Russia.
Did You Know…?
Yields and Returns:
Data suggests a tipping point when the 10-year Treasury yield crosses the 3% level. According to Barron’s and data compiled by Jim Paulsen of Leuthold Group, since 1950 when the yield on the 10-year note is below 3%, stocks have an annualized monthly return of 21.9%, but just a 10.0% annualized monthly return when that yield is over 3.0%. Volatility is higher when rates move up too. When the 10-year yield is below 3.0%, volatility was 13.5% with monthly losses occurring 28% of the time, versus volatility of 14.6% and monthly losses occurring 38% of the time when yields are over 3.0%.
The Week Ahead
Momentum to the downside could continue into this week but a very busy week on the economic and earnings calendars has the potential to swing things in either direction. It will be the busiest week this earnings season with almost 40% of S&P 500 companies set to report results this week. The five tech giants will report results this week – Alphabet and Microsoft on Tuesday, Meta (Facebook) on Wednesday, and Apple and Amazon on Thursday. Other notable releases will be from Coca-Cole and Activision Blizzard on Monday, General Motors, 3M, Chipotle, UPS, PepsiCo, GE, the first report from the combined Warner Bros Discovery, and Visa on Tuesday, Boeing, Ford, PayPal, and Qualcomm on Wednesday, Comcast, Caterpillar, Intel, Twitter, and McDonald’s on Thursday, and Chevron and Exxon Mobil on Friday. The big reports on the economic calendar are the first estimates on first quarter GDP on Thursday that is expected to show the economy grew at a 1.7% annualized pace in the quarter, down from 6.9% the previous quarter. Then Friday is the personal income and expenditures that is expected to show a 0.6% rise in spending and 0.4% increase in incomes. Other data include durable goods orders, Case Shiller Home Price Index, the Conference Board’s consumer confidence survey, and new home sales on Tuesday, weekly jobless claims on Thursday, and the quarterly employment cost index and consumer sentiment on Friday.